Sunshine Pharmaceuticals is a manufacturer engaged in the development and marketing of new drugs. The chief research chemist at Sunshine Pharmaceuticals, Dr. I. Smart, informed the president, Ms. T. Pres, that recent research results have indicated a possible breakthrough to a new drug with wide medical use. Dr. Smart urged an extensive research program to develop the new drug and estimated that with expenditures of $100,000, the new drug could be developed at the end of a year's work. When queried by Ms. Pres, Dr. Smart stated the chances were very good --approximately 90 percent-- that the research group could develop the drug.

Ms. Pres, worried about the sales prospects of a drug so costly to develop, talked to the marketing manager, Mr. Margin, who said that the market for the potential new drug depended upon the acceptance of the drug by the medical profession. Mr. Margin also stated that he had heard rumors that several other firms had been considering developing such a drug. If any firms developed competing drugs, they would have to split the market among them. Ms. Pres asked Mr. Margin to make future market estimates for different situations, including estimates of future profits. Mr. Margin made the estimates shown below:

Market Condition Likelihood Present Value of Profit

Large market potential 0.1 $500,000

Moderate market potential 0.6 250,000

Low market potential 0.3 80,000

1.0

Mr. Margin pointed out that the profit figures did not include the $100,000 costs of research and development nor the $50,000 cost of introducing the product. This $50,000 cost would be incurred only if the firm decided to enter the market after the drug was developed.

Ms. Pres was somewhat concerned about spending $100,000 for development of the drug in the face of such an uncertain market. He returned to Dr. Smart and asked whether there was some way to develop the drug more cheaply or to postpone development until the market position was clearer. Dr. Smart said that he would prefer his previous suggestion--an orderly research program costing $100,000--but that an alternate plan was indeed possible.

The alternate plan called for a low-level part plus $110,000 for the crash program. Dr. Smart believes this alternate program would have the same chances of a successful product development. One advantage of this approach, Dr. Smart added, was that the question of whether the drug could be developed successfully would be known at the end of the eight-month period. The decision could then be made at the end of eight months on whether to undertake the crash program. When consulted, Mr. Margin stated that at the end of eight months he would be able to estimate the market potential within 90%.

Ms. Pres inquired about the possibility of waiting until other drugs were on the market and then developing a drug on the basis of a chemical analysis of the competitive drug. Dr. Smart said that this was indeed possible and that such a drug could be developed for $50,000. Mr. Margin was dubious of the value of such an approach. He said that the first drugs out usually got the greater share of the market. He estimated that returns would be only about 40 percent of those given in the table. In addition, he indicated that there was a good chance, say one out of three, that no equivalent competitive drug would be marketed--in which case Sunshine Pharmaceuticals would have nothing upon which to develop a drug.

Given this is a rather complex scenario with multiple interpretations, here are a few clarifying tips:

• The first decision is whether to develop or wait. If the decision is made to develop, there are two options - full development or crash - if either of these successfully goes to market - the market options are a large, medium, or small market. Likewise, if the decision is made to wait for a copy drug, there is a similar path to the market, but with different probabilities.

• To further explore the crash path - if the crash path is successfully pursued and goes to market there would a $110,000 crash cost plus a $50,000 cost to go to market. The same large, medium, small market options would apply as the full development.

 

Requirements ::

 

1.Using the information , draw a decision tree documenting the options, costs, probabilities and outcomes. The decision tree may be created using Excel, other software, or freehand.

2.Recommend which action Ms. Pres should take to maximize her expected profit.

Note: This is a complex problem so please review the "tips" below to help complete the decision tree and recommendations: 

Each of the three major decisions/paths (12-Month Development, 8-Month Crash Development, and Wait/Develop After Market) has a chance of success or failure.Therefore, a chance node should be shown for each.

For the 12-Month Development, there is a 10% chance of failure.If failure happens, it costs $100,000.This needs to be shown and ultimately included in the final EMV calculation for that decision.Failure in the other two solutions has a probability, but does not carry a cost.

In the Wait/Develop After Market path, the estimated returns are reduced to 40% of the original estimate.

Each path includes a decision to go to market - if successful. Therefore, these paths should include a $50,000 marketing cost.

Each successful path has a low, moderate and large market condition to consider.

The probability of the occurrences found at each chance node needs to be assigned.For example, the probabilities for success and failure of each decision (90% probability of success for the 12-month development and the 8-month crash; 66% probability of success for the wait program).

After the values are entered in the tree, start at the right side of the tree and move left, calculating EMV for each chance and decision node until you get to the left side.