Merck &Co: Evaluating A Drug Licensing

Opportunity

By
Bashar Haddad ID#100986217
Ran Ji
ID#100937493
Yujia Deng ID#100985515
Qi Yao
ID#100987273
Xinyan Ma ID#100963278

TOMS 5301
Uma Kumar
4th, Feb 2015

February 4th, 2000

Mr. Rich Kender

Merck & Company

Dear Mr. Kender,

We have conducted our analysis of Mercks opportunity to license the drug Davanrik from
LAB Pharmaceuticals. Our report has taken into account the diversification benefits of
adding one more drug to your portfolio, the expensive and long winded FDA approval
process in addition to the estimated probabilities of success at each phase.

Based on our decision tree analysis and inputs from your company, we recommend that your
highest bid should not exceed $13.98 million at a 14.55% success rate. The expected value
for this contract for LAB Pharmaceuticals would be $16.68 million. We have also performed
a sensitivity analysis, whereby if costs for launching Davanrik for weight loss were 225
million instead of 100 million, it would bring the value of the project down to $10.76 for
Merck.

Our attached report provides additional details of our complete analysis methodology,
assumptions used and sensitivity analysis.

Please do not hesitate to contact us if you have any questions or requests for additional
information.

Best regards,

Executive Summary
Merck & Co., Inc, a global research-driven pharmaceutical company, provides human and
animal health products and pharmaceutical benefit management service. It has well
performed in the past few years and enjoyed high profit and growth rate. However, with the
challenge that the majority of drugs patents expired and the potential treat of profit
decreasing, the company is considering to refresh the companys portfolio by evaluating an
offer from LAB.

Currently, Davanrik, the new drug offered by LAB, is ready to enter the clinical approval
process. As the process takes 7 years to go through the three-phrase, the company needs to
evaluate the cost and benefit of this new drug. Also, it is essential to assess whether Davanrik
could help the company to generate profits and maintain growth. Therefore, Rich Kender
decided to hire us to work with his financial evaluation & analysis team to evaluate whether
the company should license Davanrik.

Our analysis is based on numerous possible outcomes throughout the FDA approval process,
launching and sales. By adopting the method of decision tree analysis, the present value of
expected cash flows from various scenarios are $13.98 million for undertaking both the FDA
approval process and licensing Davanrik and $16.68 million for payments expected to LAB.

Problem Statement
In 2000, Merck & Co., Inc. was facing the threat that patents of their most popular drugs
would expire in two years. Following by the patents' expiration, company's sales and profits
would decline dramatically since generic substitutes would take place. One way to recover
the loss caused by patents' expiration was to develop new drugs and refresh the company's
portfolio.

LAB Pharmaceuticals, who specializes in developing compounds for treatment of

neurological disorders, offered Merck to license a new developing drug, Davanrik, which had
functions to treat depression, obesity or both. At the time of the offer, Davanrik was in pre2

clinical development, which would need to pass the three-phase clinical tests approved by the
FDA. Testing would last seven years, which would appear to be costly and with high risk of
failure. Under the licensing agreement, Merck would be responsible for the approval of
Davanrik from the FDA, its manufacturing and marketing. As a return, after Davanrik
completing each stage of the approval process, Merck would pay an initial fee, a loyalty on
all sales, and make additional payments to LAB.

As a financial consulting team, we aim to analyze this offer through decision tree analysis,
estimate the expected value from each possible outcome and the expected payments to LAB,
and make recommendations to Merck.

Methodology
Both LAB and Merck should make their decisions based on the expected values of all
possible following outcomes. The basic methodologies are listed below:
By balancing the benefits and cost at the beginning of each move, both company can
either chose to continue investment or stop losing money.
To calculate the expected returns of each decision, we multiply the probability of all the
sub-events of the decision with its outcome respectively.
For Merck, we calculate the total expected PV cash inflow of the project to decide the
amount to bid.
Fob LAB, we calculate the total expected PV cash inflow from Merck to get the expected
value of licensing arrangement.

Assumptions
The prior probability given for each event equals to its posterior probability.
Both Merck and LAB are rational in making decisions.
All cash flows given are after tax and have been discounted into PV.
All events are independent, and have a total probability of 100%.
Sunk cost is not taken into consideration.

Question 1 & 2: Analysis-Decision tree and PV of the project

We have 3 components in our decision tree: the decision nod, the event nod and the terminal
value. At beginning of each phase, there is a decision to make whether to continue or stop,
some decisions may contain a cost. For each decision, there are several events
(consequences) happen at a given probability. At the end of branches, the terminal values
display the yield of a combination of decisions and events.

The decision making process includes 3 phases. Each decision is influenced by the
outcomes(s) that are expected afterwards. For example, in order to make a decision in phase
2, we have to determine the optimal outcome followed by a set of decisions in phase 3. We
simply choose to continue if the PV from the next phase is positive. To calculate the expected
value at each node, we multiply the net cash flow expected by the probability of success or
failure for that scenario. As shown in the tree below, the expected PV of the project is $13.98
million. Please refer to table below for details of calculations represented in the decision tree
used (appendix 1).
Davanrik Failure/Success Probability
Phase

Fail Probability Fail

Per Phase
Probability
Total
I
40%
40%
II
60% x 70%
42%
III Depression
60% x 10% x 15%
0.90%
III Weight Loss 60% x 15% x 25%
2.25%
III

Dual 60% x 5% x 10%

0.30%
Indication
Total

85.45%

Success Probability - Success

Per Phase
Probability
Total
60% x 10% x 85%
5.10%
60% x 15% x 75%
6.75%
60% x 5% x 70%
2.10%
60% x 5% x 15%
0.45%
60% x 5% x 5%
0.15%
14.55%

Davanrik Expected Cash Flows Millions

Phase

Fail Probability Fail

Cash flows
Probability
Total
I
-30
-30
II
-30-40
-70
III Depression
-30-40-200
-270
III Weight Loss -30-40-150
-220
III

Dual -30-40-500
-570
Indication

Success Probability - Success

Cash flows
Probability
Total
1,200-250-200-40-30
680
345-100-150-40-30
25
2,250-400-500-40-30
1,280
1,200-250-500-40-30
380
345-100-500-40-30
-325

Question 3: Revenue from LAB

In order to determine the expected value of the licensing arrangement for LAB
Pharmaceuticals, we must first determine the payments that LAB will receive from Merck
and Company. By multiplying the expected cash flow figures below with the same
probability percentages calculated above we would arrive at the expected value for each
outcome. Therefore, total expected value for this contract for LAB Pharmaceuticals would be
$16.68 million. Refer to table below for calculation and appendix 2 for decision tree used.

LAB Expected Cash Flows - Millions

Phase
Fail Probability Fail
Cash flows
Probability
Total
I
5
5
II
5+2.5
7.5
III Depression
5+2.5+20
27.5
III Weight Loss 5+2.5+10
17.5
III

Dual 5+2.5+40
47.5
Indication

Success Probability - Success

Cash flows
Probability
Total
5+2.5+20+(1200*5%)
87.5
5+2.5+10+(345*5%)
34.75
5+2.5+40+(1200*5%)
107.5
5+2.5+40+(345*5%)
64.75
5+2.5+40+(2250*5%)
160

Question 4: Sensitivity analysis

As the approval process takes 7 years, some unforeseen events could happen that might have
negative impact on the project. Also, the pharmaceutical market might be affected by
5

numerous variables, such as cost, price and government policy. Therefore, we further conduct
a sensitivity analysis to demonstrate the outcome of one possible scenario that should the
company change its decision if the cost of launching Davanrik for weight loss increased by
$125 million ($225 - $100 = $125).

There are two cases that the decision could be affected by the increased cost of launching
after Phrase II. One is weight-loss only and another is weight loss under both depression and
weight-loss. Under the first situation, there is 15% possibility that the increasing cost will
lead to a loss of $130 million if the company continues to invest in Phrase III. Comparing the
result of two possible scenarios, the company should stop this project with the minimum loss
of $70 million.

However, under the second case, the company still will be able to generate profit. Referring
to the decision tree, the weight-loss could loss $450 million by increased launching cost of
$225 million. However, the possibility of this scenario only accounts for 0.25% (weight loss
= 0.05*0.05) under Phrase III. The impact on the profit is not significant and could be offset
by other cash inflows. Therefore, we should continue our investment on Phase III, if both
depression and weight loss are effective.

By taking these two cases into consideration, the overall expected value for undertaking both
FDA approval process and licensing Deavanrik is $10.75 million. The additional launching
cost of $125 million will lead to a decrease of $3.23 million. Therefore, Merck should not
pay more than $10.75 million, if it wants to take LABs offer of licensing Davanrik.

Refer to appendix 3 for decision tree analysis.