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.

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