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. Assume that firms A and B are risk neutral. Use decision trees to justify your answer for the following problems. a) Suppose that firms A and B form a joint venture and are going to pursue A’s R&D program first and in case of its failure they will develop the medicine by B’s method. Calculate expected profits. b) You found out that forming a joint venture with B is more profitable for your firm than pursuing R&D program alone. Is it reasonable to expect that firm B will agree to cooperate?
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. Assume that firms A and B are risk neutral. Use decision trees to justify your answer for the following problems.
a) Suppose that firms A and B form a joint venture and are going to pursue A’s R&D program first and in case of its failure they will develop the medicine by B’s method. Calculate expected profits.
b) You found out that forming a joint venture with B is more profitable for your firm than pursuing R&D program alone. Is it reasonable to expect that firm B will agree to cooperate?
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