10. As CEO of firm A, you and your management team face the decision of whether...

10. As CEO of firm A, you and your management team face the decision of whether to undertake a $200 million R&D effort to create a new mega-medicine. Your research scientists estimate that there is a 40 percent chance of successfully creating the drug. Success means securing a worldwide patent worth $550 million (implying a net profit of $350 million). However, firm B (your main rival) has just announced that it is spending $150 million to pursue development of the same medicine (by a scientific method completely independent of yours). You judge that B’s chance of success is 30 percent. Furthermore, if both firms are successful, they will split equally the available worldwide profits ($275 million each) based on separate patents.

a. Given its vast financial resources, firm A is risk neutral. Should it undertake the $200 million R&D effort? (Use a decision tree to justify your answer.)

b. Now suppose that it is feasible for firm A to delay its R&D decision until after the result of B’s R&D effort (success or failure) is known. Is it advantageous for firm A to wait and claim this “second move”? (Use a decision tree to justify your answer.)

c. Instead, suppose that the two firms can form a joint venture to pursue either or both of their R&D programs. What is the expected profit of simultaneously pursuing both programs? Hint: Be sure to compute the probability that both efforts fail (in which case the firms’ combined loss is 200 + 150 = $350 million). Could the joint venture profitably pursue a single program?

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Thank you...

Rahul Sunny answered 1 year ago

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