Executive Summary In 2000, Merck & Co., Inc.

, a global research-driven pharmaceutical company, was facing a threat that patents of their most popular drugs would expire in two years. Following by the patents expiration, companys sales and profits would decline dramatically since generic substitutes would take place. The only way to recover the loss caused by patents expiration was to develop new drugs and refresh the companys 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 pre-clinical development, which would need to pass the threephase clinical tests approved by the FDA. Testing would last seven years, which would appear to be high failure and costly. Under the licensing agreement, Merck would be responsible for the approval of Davanrik from the FDA, its manufacturing, and its marketing. As return, Merck would pay LAB an initial fee, a loyalty on all sales, and make additional payments as Davanrik completed each stage of the approval process. As Mercks financial evaluation team, we analyzed this offer through decision tree analysis, and estimated the expected value from each possible outcome and the expected payments to the LAB. We concluded the expected value of licensing Davanrik is around $13.69 million, which included the expected payments to the LAB of $16.68 million. Our recommendation is that Merck should bid on licensing Davanrik no more than $13.69 million. First, the company is facing a serious situation that most of their patents are going to expire soon, and the companys value and profits are declining, so it is necessary to invest in new drug developments. Second, the FDA approval tests are seven years long with a high failure rate. If Merck fails tests in the middle way, the company would not only loss the opportunity to produce and market the drug, but also face huge loss caused by failure, so the bid can not be set too high. Third, Merck had rich experience and technology source with drug development process, so the company should have financial and technical abilities to support Davanriks approval process with the FDA. We estimated the projects expected value by sum up expected values from positive outcomes and negative outcomes, and concluded that it is worth to bid but with caution as the project will be subject to high risk. Our analysis details are as following. The Problem Merck Merck was a successful research-driven pharmaceutical company, which discovered, developed, manufactured and marketed a broad range of human and animal health products. Over the last three years, Merck had achieved close to 20% profit from sales of executive patent drugs. However, most of the revenue generators, patented drugs, were going to become generic drugs in two years. There was a sign that goodwill and intangibles were declining from 26% to 21% for 1998 to 1999, and we anticipated a deeper drop when more patents get expired in 2002. If there would be no substitutes which could take place to generate revenue after patents get expired in two years, the companys profit and EPS would decrease, which would make it less attractive to investors, so the companys value would decline. The only way to counter the loss of sales form drugs going off patent was to develop new drugs and constantly refresh the companys portfolio. From the analysis of companys common - size financial statements, it appeared that the firm was financially healthy. Moreover, Merck was able to fund new drugs development through both internal and external funding. From the common size balance sheet: All three years current ratios were greater than 1, which indicated that the company has high liquidity. The debt to equity ratios were great than 1, which seemed the company had a heavier debt than equity, but it was not the truth. Current liabilities, deferred income taxes and noncurrent liabilities, and minority interests had a larger percentage than the long-term debt in total liabilities. Additionally, there was high percentage of treasury stock in stockholders equity, which reduced the total equity. From the common size income statement: Over the last three year, the company had a high gross margin from 46% to 50%, which indicated company efficiently utilized assets to earn substantial profit. Moreover, profit margin, ROA, ROE and EPS all indicated the company was profitable, which should be attractive to both creditors and investors. Since the retention ratio was pretty high, the company was able to reach a higher return by reinvesting the retained earnings.

Overall, Mercks healthy financial position indicated that it was able to fund new drugs development internally and externally. It could invest by utilizing funding from retained earning, reselling of treasury stocks, issuing stocks to investors, or issuing bonds to creditors. Table 1 - Common Size Balance Sheet Year Ended December 31, Year Ended December 31, 1999 1998 1999 1998 Assets Current Assets Cash and cash equivalents 2,021.9 2,606.2 5.67% 8.18% Short-term investments 1,180.5 749.5 3.31% 2.35% Accounts receivable 4,089.0 3,374.1 11.47% 10.59% Inventories 2,846.9 2,623.9 7.99% 8.24% Prepaid expenses and taxes 1,120.9 874.8 3.15% 2.75% Total current assets 11,259.2 10,228.5 31.60% 32.11% Investments 4,761.5 3,607.7 13.36% 11.33% Property, Plant and Equipment (at cost) Land & Buildings 4,725.0 3,892.8 13.26% 12.22% Machinery, equipment and office furnishings 7,385.7 6,211.7 20.73% 19.50% Construction in progress 2,236.3 1,782.1 6.28% 5.59% 14,347.0 11,886.6 40.26% 37.32% Less allowance for depreciation 4,670.3 4,042.8 13.11% 12.69% 9,676.7 7,843.8 27.16% 24.62% Goodwill and Other Intangibles 7,584.2 8,287.2 21.28% 26.02% Other Assets 2,353.3 1,886.2 6.60% 5.92% 35,634.9 31,853.4 100.00% 100.00% Liabilities and Stockholders Equity Current Liabilities Accounts payable and accrued liabilities 4,158.7 3,682.1 11.67% 11.56% Loans payable and current portion of long-term debt 2,859.0 624.2 8.02% 1.96% Income tax payable 1,064.1 1,125.1 2.99% 3.53% Dividends payable 677.0 637.4 1.90% 2.00% Total current liabilities 8,758.8 6,068.8 24.58% 19.05% Long-Term Debt 3,143.9 3,220.8 8.82% 10.11% Deferred Income Taxes and Noncurrent Liabilities 7,030.1 6,057.0 19.73% 19.02% Minority Interests 3,460.5 3,705.0 9.71% 11.63% Stockholders Equity Common Stock 29.7 29.7 0.08% 0.09% Other Paid-in capital 5,920.5 5,614.5 16.61% 17.63% Retained earnings 23,447.9 20,186.7 65.80% 63.37% Accumulated Other Comprehensive Income (loss) 8.1 (21.3) 0.02% -0.07% 29,406.2 25,809.6 82.52% 81.03% Less treasury stock, at cost 16,164.6 13,007.8 45.36% 40.84% Total stockholders equity 13,241.6 12,801.8 37.16% 40.19% 35,634.9 31,853.4 100.00% 100.00% Table 2 - Common Size Statement of Income & Retained Earnings Year Ended December 31, Year Ended December 31, 1999 1998 1997 1999 1998 1997 Sales 32,714.0 26,898.2 23,636.9 100.00% 100.00% 100.00% Costs, Expenses, and Other Materials and production 17,534.2 13,925.4 11,790.3 53.60% 51.77% 49.88% Gross margin 15,179.8 12,972.8 11,846.6 46.40% 48.23% 50.12% Marketing and administrative 5,199.9 4,511.4 4,299.2 15.90% 16.77% 18.19% Research and development 2,068.3 1,821.1 1,683.7 6.32% 6.77% 7.12%

Acquired research 51.1 1,039.5 0 0.16% 3.86% 0.00% Equity income from affiliates (762.0) (884.3) (727.9) -2.33% -3.29% -3.08% Gains on sales of businesses 0 (2,147.7) (213.4) 0.00% -7.98% -0.90% Other (income) expense, net 3.0 499.7 342.7 0.01% 1.86% 1.45% 24,094.5 18,765.1 17,174.6 73.65% 69.76% 72.66% Income Before Taxes 8,619.5 8,133.1 6,462.3 26.35% 30.24% 27.34% Taxes on Income 2,729.0 2,884.9 1,848.2 8.34% 10.73% 7.82% Net Income 5,890.5 5,248.2 4,614.1 18.01% 19.51% 19.52% Basic Earnings per Common Share 2.51 2.21 1.92 0.01% 0.01% 0.01% Earnings per Common Share Assuming Dilution 2.45 2.15 1.87 0.01% 0.01% 0.01% Retained Earnings Balance, January 1 20,186.7 17,291.5 14,772.2 61.71% 64.28% 62.50% Net Income 5,890.5 5,248.2 4,614.1 18.01% 19.51% 19.52% Common Stock Dividends Declared (2,629.3) (2,353.0) (2,094.8) -8.04% -8.75% -8.86% Retained Earnings Balance, December 31 23,447.9 20,186.7 17,291.5 71.68% 75.05% 73.15% Table 3 - Financial Ratio Analysis 1999 1998 1997 Current Ratio 1.29 1.69 Total Debt Ratio .63 .60 Debt/Equity Ratio 1.69 1.49 Equity Multiplier 2.69 2.49 Profit Margin 18.01% 19.51% 19.52% ROA 16.53% 16.48% ROE 44.48% 41.00% EPS 2.51 2.21 1.92 Retention Ratio 55.36% 55.17% 54.60% Dividend Payout Ratio 44.64% 44.83% 45.40% Internal Growth Rate 10.07% 10.00% Sustainable Growth Rate 32.68% 29.22% LAB Pharmaceuticals LAB, a specialized pharmaceutical company, was offering Merck to license his new developing drug, which was ready to enter the three-phase clinical testing. LAB already had a few drugs under the three testing phases. Some were denied by the FDA after all three tests, and others were still under testing phases, so none of them successfully completed the FDA approval. LABs stock price dropped 30% due to failure of testing approval. Therefore, LAB could not raise enough funds to support Davanrik to pass all three phases and get approval from the FDA, and they were looking for a larger company, who had financial ability to successfully complete clinical tests, and launch the drug into market. In return, LAB would receive an initial payment, additional payments as Davanrik completes each clinical testing phase, and a royalty based on Danvanriks sales. Drug Development On average, it takes 13 years for an experimental drug to travel from lab to market. All new drugs need proof that they are effective, as well as safe, before they can be launched into market. It is the FDAs responsibility to assure the safety and efficacy of all drugs. The average rate for a new drug to pass all tests and to get approval from the FDA is one out of 50,000 or lower. Table 4 - Compound Success Rates by Stage Discovery Preclinical Testing Phase I Phase II Phase III FDA Post-marketing Testing Years 2 to 10 4 2 2 3 2 Test Population Laboratory and animal testing 20-80 healthy volunteers 100-300 patient volunteers 1000-5000 patient volunteers Purpose Assess safety and biological activity Determine safety and dosage Look for efficacy and side effects Monitor adverse reactions to long-term use Additional post-marketing testing Success Rate 5000-10000 screened 250 enter preclinical testing 5 Enter clinical testing 1 approved Once the drug is approved by FDA, it will commercialize and be protected by patent for another ten years. Even though it is very time consuming and costly to successfully develop and launch a new drug into the

market, the revenue generated by a patented drug is significant. Pharmaceutical companies will have excusive rights to produce and sell the drug with low costs. After the patent expires, the drug becomes generic, which can be legally produced by generic drug manufacturers. The expiration of a patent removes the monopoly of the patent holder on drug sales licensing, which will have huge impact in the patent holders sales. Pharmaceutical companies revenue and profit will decline, which causes stock price to drop. Merck had an opportunity to bid on licensing Davanrik, which might generate revenue if the drug successfully gets approval from the FDA. It is a long-term investment with high uncertainty and high failure risk. It is also a high competitive industry that a company will land itself in a passive position once it losses its most patent rights, which was exactly the situation Merck had been facing to. Should Merck bid to license to Davanrik? What is the maximum bid they would be willing to pay? To evaluate this investment, Merck must look at outcomes from each phase, and their possibilities of success and failure. The bidding strategy should be based on the expected value of all possible outcomes. Also keep in mind that the FDA approval has a relative low passing rate 0.02% or lower, which means there are high chances that the tests will fail at any phase with a substantial loss. Methodology The bidding decision should be based on the evaluation of expected value from Davanriks potential testing outcomes. 1. We would need to be familiar with the FDA phases of Davanriks development, and the possibilities of passing or failing at each phase. We could utilize decision tree analysis to estimate success and failure possibilities for each outcome. 2. We have to track on costs of development from each stage including payments to LAB, costs in testing phases, costs to launch, and loyalty to LAB. And then we could calculate the total cash outflow and inflow for each outcome. 3. We would calculate NPV for each outcome by subtracting cash outflow from inflow, and then compute expected value by multiplying NPV to each outcomes success or failure possibility. 4. We would estimate the expected payments to the LAB including the initial fee, milestone payments and royalty. 5. The maximum bid should be based on sum of the expected value of all possible outcomes. Data Requirements 1. To estimate the success or failure rate of each potential outcome, we would need possibilities of success and failure of depression, weight loss and dual for each testing phase. 2. To estimate cash outflow and inflow for each potential outcome, we would need all payments to LAB by phase, costs incurred in each phase, costs to launch into market, and loyalty paid to LAB. Assumptions The following assumptions were made in order to properly evaluate this investment. 1. All cash flows given in the case were discounted to prevent value. 2. Possibilities of all outcomes in any one testing phase add up to 100%. 3. The overall possibilities of final potential outcomes add up to 100%. 4. Royalty will be paid to LAB at a rate of 5% of the commercialized PV. 5. Initial payment, milestone payments and royalty to LAB are also subject to the same risk as the test success and failure rates at each phase. 6. All launches are successful. 7. Ignore tax implication for cash flow. Analysis Davanrik Expected Value First, we created a decision tree to analyze success or failure possibilities for potential outcomes for each phase. Possibilities of success and failure, and cash flows in each stage were listed below. We conclude that there were five successful outcomes: depression only, weight-loss only, dual, depression from dual trial and weight-loss from dual trial. Accordingly there were five failures: failure at phase I, failure at phase II, failure at phase III at depression test, failure at phase III at weight-loss test and failure at phase III at dual test. In total, there were ten possible outcomes with different success and failure rates. Table 5 - DECISION TREE Phase III Launch Loyalty PV NPV

Phase II Success - 85% -250 -3.06 1200 676.94 Depression - 10% -200 Failure - 15% 0 Success - 75% -100 -1.16 345 23.84 Weight Loss - 15% -150 Failure - 25% Phase I 0 Success - 60% Depression - 15% -250 -0.27 1200 379.73 -40 Dual - 5% -500 Weight Loss - 5% -100 -0.03 345 -325.03 Dual - 70% -400 -2.36 2250 1277.64 Failure - 10% 0 License Failure - 70% -30 0 Failure - 40% 0 No License 0 Second, we listed cash outflows and possibilities of success or failure in phase I, II, III based on testing objectives. Then we estimated possibilities for ten potential outcomes concluded from the decision tree by multiplying possibility of success or failure at each phase. We assume that 5% royalty based on commercialization PV to the LAB would have the same rates as the five successful outcomes concluded from the decision tree. We summed up cash outflows for each outcome. After that, we compute net present value using: NPV = cash inflow cash outflow. Third, we estimated the expected value for ten individual outcomes: EV = NPV * possibility of success/failure Last, the expected value of licensing equals to the sum of expected values of all ten outcomes. We estimated that sum expected value was $13.69 million, which should be the maximum bid for this investment. Table 6 - Cash Flow and EV Calculation Stage Function Cash Outflow Cash Inflow Possibility of Success / Failure NPV Expected Value I Success (30) 60% Failure (30) 40% II Depression - success (40) 10% Weight Loss (40) 15% Dual (40) 5% Failure (40) 70% III Depression (200) 85% Depression - failure (200) 15% Weight Loss (150) 75% Weight Loss - failure (150) 25% Dual - Depression (500) 15% Dual - Weight Loss (500) 5% Dual - Dual (500) 70% Failure (500) 10% Launch Depression (250) 100% Weight Loss (100) 100% Dual (400) 100%

Loyalties Depression (3.06) 5.10% Dual - depression (0.27) 0.45% Weight Loss (1.16) 6.75% Dual - Weight Loss (0.03) 0.15% Dual (2.36) 2.10% Successful Depression (523.06) 1,200 5.100% 676.94 34.52 Outcomes Dual - depression (820.27) 1,200 0.450% 379.73 1.71 Weight Loss (321.16) 345 6.750% 23.84 1.61 Dual - Weight Loss (670.03) 345 0.150% (325.03) (0.49) Dual (972.36) 2,250 2.100% 1,277.64 26.83 Failed Failure at Phase I (30.00) - 40.00% (30.00) (12.00) Outcomes Failure at Phase II (70.00) - 42.00% (70.00) (29.40) Failure at Phase III - Depression (270.00) - 0.90% (270.00) (2.43) Failure at Phase III - Weight Loss (220.00) - 2.25% (220.00) (4.95) Failure at Phase III - Dual (570.00) - 0.30% (570.00) (1.71) Total 100% 13.69 Expected Payments to LAB Payments to LAB consist of initial payment, milestone payments with successful test result, and 5% royalty based on commercialization present value. Milestone payments and royalty also bear the same risk as tests at each phase. Total Payments to LAB = PV of Initial and Milestone Payment + PV of Royalty = 9.80 + 6.88 = 16.68 (million) Table 7 - Payments to LAB Phase Payment Probability of Success PV of Payment Initial 5.00 100% 5.00 Phase I Success 2.50 60% 1.50 Phase II Depression 20.00 60%*10% 1.20 Phase II Weight Loss 10.00 60%*15% 0.90 Phase II Dual 40.00 60%*5% 1.20 Total 9.80 Loyalties Payment Probability of Success PV of Payment Depression 1200*.05 5.10% 3.06 Dual - depression 1200*.06 0.45% 0.27 Weight Loss 345*.05 6.75% 1.16 Dual - Weight Loss 345*.05 0.15% 0.03 Dual 2250*.05 2.10% 2.36 Total 6.88 Conclusions and Concerns Our evaluation was based on decision tree analysis and expected value computation. We estimated ten potential outcomes from the three testing phases independently. Among them, there were five success and five failures. The sum of expected return from these ten outcomes was $13.69 million, which represented the maximum value Merck could get back from licensing Davanrik. Merck should have walked away if the bid had gone over $13.69 million. There are concerns related to this investment. First, as the analysis indicated that there is high failure rate associated with clinical testing and the FDA approval. The average rate of passing all tests and getting proof from the FDA is one out of 5000 or lower. Second, the clinical testing is seven-year long, and cost 200 to 350 million dollars on average. Since Merck will not receive revenue or profit at least for seven years, the company has to face a lot of uncertainties, such as economic changes, government regulations and restrictions, and operating risks in a long development period. Third, the testing could fail at any phase, which will lead to substantial costs. The costs will be $70 million or lower if it fails at the early stages, such as phase I or II. As

the test fails at phase III, the losses will raise up from $220 million to $570 million. Overall, could Merck bear a high risk investment with no return in at least seven year? References Merck & Company: Evaluating a Drug Licensing Opportunity, Harvard Business School, Case #9201-023, March 25, 2003.