It is January 1, 2006, and Lilly is considering developing a new drug called Dialis. We are given the following information
■ On March 15, 2006, Lilly incurs a fixed cost that is assumed to follow a triangular distribution with best case $10 million, most likely case $35 million, and worst case $50 million. This cost will be depreciated on a straight-line basis during the years 2007 to 2012.
■ The product will be sold during the years 2007 to 2012. In years 2007 and 2008, the product will be sold only in the United States, but starting in 2009, Lilly might sell the product overseas. The 2007 market size in the United States is assumed to be between 500,000 and 3,000,000 units. A market size of 1,000,000 units is assumed to be twice as likely as a market size of 700,000, and a market size of 2,000,000 units is assumed to be three times as likely as a market size of 700,000.
■ Lilly’s 2007 market share is assumed to follow a triangular distribution with worst case 10%, most likely case 20%, and best case 30%. Lilly assumes that its market share will remain the same unless a competitor enters the market.
■ The growth rate in market size in later years is assumed to be the same each year. In the first year, it is assumed to follow a triangular distribution with worst case 5% annual growth, most likely case 12% annual growth, and best case 14% annual growth.
■ A single competitor might enter the market. Each year, the competitor has a 30% chance of entering the market, assuming it has not already entered. The year after entering the market, a competitor causes a permanent loss of 40% of Lilly’s market share. For example, suppose the competitor enters in 2008, and Lilly’s share was 20%. Then in the years 2009 to 2012, its market share will be 12%.
■ At the beginning of 2009, Lilly will decide whether to sell Dialis overseas. If no competitor has entered the market by the end of 2008, there is a 70% chance that Lilly will sell the product overseas. If a competitor has entered the market by the end of 2008, there is only a 30% chance that Lilly will sell the product overseas. Lilly’s market share overseas will equal its market share in the United States. It estimates that the overseas market is 25% of world sales for drugs of this type. (The other 75% is U.S. sales.)
■ Each year the product sells for $120 and incurs a unit cost of $80.
■ Cash flows are discounted at 15% annually, and profits are taxed at 40%.
■ Cash flows for years 2007 to 2012 take place midyear.
Use simulation to model Lilly’s situation. Based on the simulation output, Lilly can be 95% sure the NPV for this project is between what two numbers? Would you go ahead with this project? Explain why or why not. (Hint: The way the uncertainty about the market size in 2007 is stated suggests using the General distribution from Section 11.3 in Chapter 11.)