It is January 1 of year 0, and Merck is trying to determine whether to continue development of a newdrug. The following information is relevant. You can assume that all cash flows occur at the ends of therespective years.■ Clinical trials (the trials where the drug is tested on humans) are equally likely to be completed in year1 or 2.■ There is an 80% chance that clinical trials will succeed. If these trials fail, the FDA will not allow thedrug to be marketed.■ The cost of clinical trials is assumed to follow a triangular distribution with best case $100 million,most likely case $150 million, and worst case $250 million. Clinical trial costs are incurred at the end ofthe year clinical trials are completed.■ If clinical trials succeed, the drug will be sold for five years, earning a profit of $6 per unit sold.■ If clinical trials succeed, a plant will be built during the same year trials are completed. The cost of theplant is assumed to follow a triangular distribution with best case $1 billion, most likely case $1.5 billion,and worst case $2.5 billion. The plant cost will be depreciated on a straight-line basis during the fiveyears of sales.■ Sales begin the year after successful clinical trials. Of course, if the clinical trials fail, there are no sales.■ During the first year of sales, Merck believe sales will be between 100 million and 200 million units.Sales of 140 million units are assumed to be three times as likely as sales of 120 million units, and salesof 160 million units are assumed to be twice as likely as sales of 120 million units.■ Merck assumes that for years 2 to 5 that the drug is on the market, the growth rate will be the sameeach year. The annual growth in sales will be between 5% and 15%. There is a 25% chance that theannual growth will be 7% or less, a 50% chance that it will be 9% or less, and a 75% chance that it will be12% or less.■ Cash flows are discounted 15% per year, and the tax rate is 40%.Use simulation to model Merck’s situation. Based on the simulation output, would you recommend thatMerck continue developing? Explain your reasoning. What are the three key drivers of the project’s NPV?(Hint: The way the uncertainty about the first year sales is stated suggests using the General distribution,implemented with the RISKGENERAL function. Similarly, the way the uncertainty aboutthe annual growthrate is stated suggests using the Cumul distribution, implemented with the RISKCUMUL function. Lookthese functions up in @RISK’s online help.)
It is January 1 of year 0, and Merck is trying to determine whether to continue development of a new
drug. The following information is relevant. You can assume that all cash flows occur at the ends of the
respective years.
■ Clinical trials (the trials where the drug is tested on humans) are equally likely to be completed in year
1 or 2.
■ There is an 80% chance that clinical trials will succeed. If these trials fail, the FDA will not allow the
drug to be marketed.
■ The cost of clinical trials is assumed to follow a triangular distribution with best case $100 million,
most likely case $150 million, and worst case $250 million. Clinical trial costs are incurred at the end of
the year clinical trials are completed.
■ If clinical trials succeed, the drug will be sold for five years, earning a profit of $6 per unit sold.
■ If clinical trials succeed, a plant will be built during the same year trials are completed. The cost of the
plant is assumed to follow a triangular distribution with best case $1 billion, most likely case $1.5 billion,
and worst case $2.5 billion. The plant cost will be depreciated on a straight-line basis during the five
years of sales.
■ Sales begin the year after successful clinical trials. Of course, if the clinical trials fail, there are no sales.
■ During the first year of sales, Merck believe sales will be between 100 million and 200 million units.
Sales of 140 million units are assumed to be three times as likely as sales of 120 million units, and sales
of 160 million units are assumed to be twice as likely as sales of 120 million units.
■ Merck assumes that for years 2 to 5 that the drug is on the market, the growth rate will be the same
each year. The annual growth in sales will be between 5% and 15%. There is a 25% chance that the
annual growth will be 7% or less, a 50% chance that it will be 9% or less, and a 75% chance that it will be
12% or less.
■ Cash flows are discounted 15% per year, and the tax rate is 40%.
Use simulation to model Merck’s situation. Based on the simulation output, would you recommend that
Merck continue developing? Explain your reasoning. What are the three key drivers of the project’s NPV?
(Hint: The way the uncertainty about the first year sales is stated suggests using the General distribution,
implemented with the RISKGENERAL function. Similarly, the way the uncertainty aboutthe annual growth
rate is stated suggests using the Cumul distribution, implemented with the RISKCUMUL function. Look
these functions up in @RISK’s online help.)
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