Weston Pharmaceuticals VP of research is evaluating a research proposal for a new drug. She believes that if pursued, and if successful, the proposal’s future benefits will be $500 million (which she estimates to have a present value of $200 million today). However, both the cost and the success of the project are uncertain. Regardless of the cost, she believes that the project has only a 25% chance of success – if it fails, Weston will still bear the entire cost, but will receive no benefits. She believes that the cost of the project (at present value) will be: Cheap project: $20 million with a probability 30%

Moderate project: $40 million with a probability of 40%

Expensive project: $60 million with a probability of 30%

But the VP cannot now or later observe the actual cost of the project. Assume that the head of the research team proposing the new drug knows the cost, and is able to use any additional funds budgeted. The head of the research team does NOT know whether or not the project will be successful, but agrees that the project has a 25% chance of success. Finally, assume that the VP of research will announce a budget cap for the new drug, which cannot be exceeded (so if the head of the research team knows that the project will cost more than the budget, the project will not be undertaken).

1. In the absence of a goal congruence problem (e.g., if the head of the research team and the VP of research were the same person), what budget cap would be set? What would the expected net present value of the project be to Weston (including the possibility that it is not undertaken)?

2. Briefy (one or two sentences) explain the goal congruence problem between the VP of research and the head of the research team.

3. With the goal congruence problem, what budget cap should the VP of research set? What is the expected net present value of the project to Weston (including the possibility that it is not undertaken)?