Quack Pharmaceuticals is exploring the possibility of developing a new drug, Symilin, which has shown promise in the treatment of two different ailments: diabetes and obesity. Drug development in US typically goes through 3 phases of clinical approval process at FDA. In Phase I, the drug is given to a small number of healthy volunteers to test for its safety. This usually takes about 18 months. In Phase II, the drug is tested on large number of patients to determine if it is effective in treating a certain condition and to measure its potential side effects. This usually takes about 2.5 years. Finally, in Phase III, tests are administered on an even larger (and substantially higher) number of patients to determine the safety and efficacy of the treatment. This phase takes about 3 years to complete.

Symilin is currently in pre-clinical development and is ready to enter the first of the three phases of clinical approval process required by FDA. After a comprehensive internal evaluation process, Quack Pharma has collected information regarding the costs and risks associated with the R&D process. These details are given below:

Phase I: Symilin would be administered to 20-80 healthy people to determine if the drug is safe enough to continue into the efficacy stages of clinical testing. Phase I would take 18 months to complete. It was expected to cost $60 million. There was a 50% chance that Symilin would successfully complete Phase I.

Phase II: The primary purpose of this phase is to determine the efficacy of Symlin for treating diabetes and/or obesity and to document any side effects. To complete the efficacy tests, Symilin would have to demonstrate a statistically significant improvement on patients suffering from diabetes, obesity, or both. At the completion of Phase II, there are 3 possible outcomes:

Symilin is effective for treating only diabetes. The probability of this outcome is 10%.

Symilin is effective for treating only obesity. The probability of this outcome is 15% .

Symilin is effective for treating both diabetes and obesity. The probability of this outcome is 5%.

Symilin is not effective for any treatment and should be discontinued. The probability of this outcome is 70%

Phase II would require 2.5 years of clinical testing to complete. Phase II was expected to cost $80 million.

Phase III: The third phase is much larger in scope and scale, and would require testing to be conducted on 1000-5000 volunteers to determine safety and efficacy in long term use. Because of the number of volunteers and nature of testing, this is the most costly of the phases. Also, the costs and probabilities of success depend on the outcome from Phase II.

If Symilin was effective for only diabetes, Phase III trials would cost $400 million. Subsequent to the trials for this scenario, there is an 85% chance it would be approved for treating diabetes. If Symilin was shown to be effective for only obesity during Phase II, the Phase III trials would cost $300 million, and have a 75% chance of approval.

More specialized trials would be required to determine efficacy of the drug if Symilin was shown to be effective for both treatments (diabetes and obesity) during Phase II trials. The total cost of the Phase III clinical trials for this scenario is expected to be $1 billion. After the trials, there is a 70% chance that the FDA would be approve the drug for both diabetes and obesity treatments. Also, there was a 15% chance that the drug would be approved only for diabetes, and a 5% chance that it is would be approved only for obesity. Finally, the probability of complete failure i.e. Symilin is not approved for either treatment is 10%.

Quack Pharma would be able to generate substantial potential profits, especially if Symilin was effective both as a treatment for diabetes and weight loss. If the drug were approved only for the treatment of diabetes, it would cost $500 million to launch, and had a commercialization value of $2.5 billion. If it were only approved for obesity treatment, it would cost $200 million to launch, and would have a value of $700 million. However, if Quack could launch the product with claims for both indications, it would cost $750 million to launch and have a value of $5 billion.

Answer the following questions with excel and show formulas based on the description above. All cash flows, including capital expenditures, are expressed as after-tax present values discounted to time zero.

1. Using the data from the case, analyze the decision making setup for Quack Pharma and calculate the value that they can generate by going through the development process described above?

2. How would your analysis change if the costs of launching (in the commercialization phase) of Symilin for obesity were $400 million instead of $200 million as given in the case? Determine the corresponding value from the development process.

3. The Quack R&D team believes that it is equally likely that the launch costs of Symilin for migraine could be 400mn or 200mn (probability of each of these cases is 50%). Now suppose Quack could conduct a separate analysis to accurately estimate the launch costs of Symilin for obesity treatment before the beginning of Phase III (i.e. after the end of Phase II but before the beginning of Phase III). What is the maximum cost that Quack Pharma should incur to conduct such an analysis?

4. Suppose Quack can conduct the above analysis (in part 3) prior to the start of Phase I. How will the cost they are willing spend on such an analysis compare with the cost calculated in part 3 above. Are they same or different? Why?