Example 7 A firm is planning to develop and market a new drug.
The cost of extensive research to develop the drug has been estimated at
Rs. 100000. The manager of the Research programme has found that there
is a 60% chance that the drug will be developed successfully. The market
potential has teen assessed as follows:
Market condition Prob. Present value of profit (Rs.)
Large Market potentiat Ot 50,000
Moderate Market potential 0.6 25,000
Low Market potential 03 10,000
The present value figures do not include the cost of research. While
the firm is considering this proposal, a second proposal almost similar
comes up for consideration. The second ene also requires an investment
of Rs.1,00,000 but the present value of all profits is 12,000. The return on
investment in the second proposal is certain.
@ Drawa decision tree indicating all events and choices of the firm.
(i) What decision the firm should take regarding the investment of
Rs. 1,00,0007Solution
PV of Profit
Re, 50,000
Ris. 25,000
Rs. 10,000
Fig.1 Decision Tree
At Point D,
Decisions are (1) Enter market (2) Do not enter market.
@ Enter market :
EMV =ExpectedP V
= (70000 x 1) +(25000 x -&) + (.0000x,3)
=5000+ 15000+ 3000 =23000
(b) Do not enter market
EMV=Expected PV =0 x 1=0
Decision: Enter the market since EMV is more.
AtD,
Decisions are (1) Develop new drug (2) Accept proposal II
{a) Develop new drug
EMV = Expected PV = (23000 x .6)+(0 x 4)= (13800 +0)=13800
(b) Accept Proposal IT
EMV = Expected PV = 12000 x 1 = 12000
Using EMV criterion, the optimal decision at D, is to develop and
narket the new drug,