The pharmaceutical industry is composed of both large and small firms competing for new research, the introduction of new products, and the sales of existing products. Performing research and development for new drugs can be financially risky, as few researched drugs actually make it to the market. Sometimes, large firms will enter into agreements with smaller firms to conduct research. There are benefits to both parties in these situations. The biggest advantage is that the large firm does not need to invest in-house for required expertise and facilities to develop a new type of drug. In essence, large firms contract out their research work to smaller firms for an investment amount smaller than what the large firms would have to spend if they conducted the new research internally. On their part, small firms receive much-needed funds to carry out their research.
Merck Co. and Genetics, Inc. are publicly traded large and small pharmaceutical firms, respectively. Merck Co. is considering entering into an agreement with Genetics. The agreement would require Merck to give $4M to Genetics to develop a new drug over the next two years. By doing so, Merck would obtain the right to acquire Genetics for $60 per share three years from today. If the new drug is successful, Genetics' share price is expected to double or even triple. However, if the new drug is unsuccessful. Genetics' share price is expected to decrease in value significantly. Genetics has a current stock price of $30 per share, has an expected share price volatility of 50% (including the riskiness surrounding the new-drug research), and has 1.2 million shares outstanding.
(a) Is the initial $4M that Merck is agreeing to pay Genetics justified? (Quantify your answer, and assume the risk-free rate is 6%.)
(b) Assume that Merck could also buy Genetics today for $40 per share. Compare buying Genetics today versus entering into the aforesaid agreement. Briefly discuss the advantages and disadvantages of both alternatives. If you utilize the binomial lattice approach, then only use a one-period lattice for your computations.