As per the paper at hand:

Merck would be responsible for:

1) the approval of Davanrik
2) the manufacture of Danavrik
3) marketing of Danavrik

Merck would pay LAB for:

1) initial fee
2) royalty on all sales
3) make additional pymts as Danavrik completed each stage of approval process (3 Phases)
approval process should take 7 years
patent will cover 17 years (7 of approval process nad 10 yr period of exclusivity beginning in yr 7)

Below are my assumptions:

All Cash flows are expressed as after tax present values discounted to time zero, including capital expenditures
At any point "failure," investment decision is to stop funding
Assuming Standard deviation of 0.5
Using T= 7 years

2 Decision Tree:
See worksheet "Decision Tree"

3 Detailed description of Real Option Technique
"First, using a decision tree, I came up with a simple expected value of \$13,980,000 based on the costs to complete each phase, the probabilities of completing each phase, and the costs and probabilities associated with failure at each step in the approval process.   The expected value of successful completion with Depression only was \$36,390,000, for weight only \$1,200,000 and for both \$26,880,000.   The expected value of failure (including failure at any phase) was (\$59,490,000).
Next, I calculated the Valuations of each successful outcome using the decision tree analysis and the spectrum of outcomes with an assymetric distribution of rewards.   Using the probability of 14.55%, which is the combined probability for any success, I recalculated the valuations of each success (Depression only, Depression only after testing for both in phase III, Weight only, etc).   This gave me some drastically different valuations for those outcomes that had very small probabilities to begin with and ended with a summed expected value for the project of (\$6,120,000).   See the table below. "... [continues]

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