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 megamedicine. 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 firm A 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 have this “second move”? (Use a decision tree to justify your answer.) c. Instead, suppose that firm A and firm B 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?
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 megamedicine.
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 firm A
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 have this “second move”? (Use a
decision tree to justify your answer.)
c. Instead, suppose that firm A and firm B 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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