Reference no: EM13880316

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 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?