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A pharmaceutical company is in the process of developing a new
drug. The development is planned in two stages. The first stage
costs one million dollars, and the second stage costs two million
dollars. If the development is successful it will result in
revenues of five million dollars. All dollars are in present value,
and discounting is not necessary. The chance of successful
development is 72%. If the development effort is a failure, there
would be no revenue, and all the investment will be a loss. The
company has the option not to develop the new drug.
Draw a decision tree to model this problem. Solve the problem by
rolling back the tree.
The company has the option of conducting a test at the end of
the first phase, at a cost of $250,000. There is an 80% chance that
the drug passes the test, and a 20% chance that the drug fails the
test. If the drug passes the test there is a 90% chance that it
will be a success and a 10% chance it will be a failure. Draw a
decision tree including the test option. Solve the decision tree by
rolling back the tree.

$5 mn


Successful Development (0.72)




Compare the results for 1 and 2, and debate if testing improves
the company’s decision-making ability.       


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