Question

Jackson Pharmaceuticals Inc. is considering funding a research team to cure Lyme’s disease. Bill Mackenzie, executive VP of research, must ultimately make this decision. The research program has a total price tag of $10M (million), and there is no guarantee that it will be successful. In fact, Bill estimates only a 40% chance that they will find a cure. If the research team finds a cure, Jackson Pharmaceuticals must then decide whether they wish to produce the drug themselves or sell the license to a chemical lab for $40M revenue. If they produce the product themselves and production goes smoothly, they forecast a revenue of $60M. However, refitting one of their production facilities is not without risk. There is a 30% chance of production troubles, in which case they would earn only $20M revenue.

What should Bill McKenzie do? (Result: Expected Monetary Value or payoff from a successful R&D project = $9.2 M)

How do you think the probability, cost, and revenue information used in this analysis were obtained?

Answer 1

As per the information provided Jackson Pharmaceuticals Inc. is considering funding a research team to cure Lyme’s disease. Bill Mackenzie, executive VP of research, must ultimately make this decision.

Total price tag of the research program = $10M (million)

and there is no guarantee that it will be successful. In fact, Bill estimates only a 40% chance that they will find a cure.

Alternative 1: Sell the license to a chemical lab

Following statistical/mathematical techniques of risk evaluation in capital budgeting, we are here using Expected Net Present Value Mehod

In this method, Using the concept of probability in the risk analysis techniques, Probability distribution can be used to compute expected values by multiplying values with probability of each outcome.

Estimated Probability = Revenue x Estimated Probability

= 40% or 0.4

= 16

So Expected Value = $40M x 0.4 = $16M

Net Present Value = Casf Flows of Inflows - Cash Flow of Outflows

= 16 -10

=6

Expected Monetary Value or payoff from a successful R&D project (ALTERNATIVE 1) = $6M

Alternative 2: To produce the product themselves

Given that if production goes smoothly = revenue of $60M.

If there are production troubles = $20M revenue (30% Probabibilty)

Expected NPV = Revenue x Estimated Probability

Since there are 2 outcomes Multiply values with probability of each outcome

Expected NPV = 60 x 0.7 + 20x0.3

=42+6

=48

Now again Estimated Probability = Revenue x Estimated Probability

= 48 x 40%

= $19.2M

Net Present Value = Casf Flows of Inflows - Cash Flow of Outflows

= 19.2 - 10

=9.2

Expected Monetary Value or payoff from a successful R&D project (Alternative 2) = $9.2M

Since NPV is higher for Alternative 2, it must be chosen. Bill Mackenzie should make the final decision that Jackson Pharmaceuticals must produce the drug themselves