268 Part Three Best Practices in Capital Budgeting
bre44380_ch10_249-278.indd 268 10/08/15 09:51 AM
We work back through the tree from right to left. The NPVs at the start of phase III trials are:NPV(upside) = −130 + .8 × _______^700
(1.096)^3= +$295 millionNPV(most likely) = −130 + .8 × _______^300
(1.096)^3= +$52 millionNPV(downside) = −130 + .8 × _______10 0
(1.096)^3= −$69 millionSince the downside NPV is negative at –$69 million, the $130 million investment at the start
of phase III should not be made in the downside case. There is no point investing $130 million
for an 80% chance of a $100 million payoff three years later. Therefore the value of the R&D
program at this point in the decision tree is not –$69 million, but zero.
Now calculate the NPV at the initial investment decision for phase II trials. The payoff
two years later depends on whether the drug delivers on the upside, most likely, or downside:
a 25% chance of NPV = +$295 million, a 50% chance of NPV = +$52 million, and a 25%BEYOND THE PAGE
mhhe.com/brealey12eTry It! Figure 10.7:
Decision tree for
the pharmaceutical
project◗ FIGURE 10.7
A simplified decision tree for pharmaceutical R&D. A candidate drug requires an $18 million investment for
phase II clinical trials. If the trials are successful (44% probability), the company learns the drug’s scope of
use and updates its forecast of the drug’s PV at commercial launch. The investment required for the phase
III trials and prelaunch outlays is $130 million. The probability of success in phase III and prelaunch is 80%.Fail
PV = 0SucceedLearn
potential
PVPhase II Trials, 2 yearsPhase III Trials and prelaunch (3 years)44%
56%
Invest 18?Fail, PV = 0Upside
PV = 700Invest 130?Yes, NPV = 1 295Succeed
80%
20%Most likely
PV = 300Invest 130?Yes, NPV = 1 52Succeed
80%
20%25%50%25%Downside
PV = 100Invest 130?STOP, PV = 0Succeed
80%
20%Fail, PV = 0Fail, PV = 0