2013

Merck and Company: Evaluating a Drug

Licensing Opportunity

Subject: Quantitative Techniques III

Professor: Prof. Bhavin J. Shah

Prepared By:
Group No: 3 Ankur Sinha (03)
Date: 6th March, 2013 Arvind Kumar (05)
Gunreet Kaur Thind (11)
IIM Indore PGP Mumbai Karri Kartik (14)
Batch of 2014 Pradyoth C John (23)
Sandeep Sayal (28)
Abhijeet Panwar (35)
 Table of Contents

1. INTRODUCTION........................................................................................................ 3
1.1 Situation Analysis………………………………………………………………………………………………………3
1.2 Objective……………………………………………………………………………..……………………………………3
1.3 Problem Statement………………………………………………………………..…………………………………3

2. ANALYSIS ................................................................................................................... 4
2.1 Alternate course of action ............................................................................................. 4
2.2 Decision Tree.................................................................................................................. 5
2.3 Should Merck bid for the license? ................................................................................. 6
2.4 Expected value of licensing arrangement to LAB .......................................................... 6
2.5 Sensitivity analysis…………………………………………………………………….8

3. REFERENCES……………………………………………………….........................9

QT-3 Assignment Merck and Co Page 2

 1. INTRODUCTION

1.1SITUATION ANALYSIS – RELEVANT CASE FACTS

 Merck is a global research driven pharmaceutical company that discovers, develops,

manufactures and markets a broad range of human and animal health products.
 Merck earns most revenue from a handful of patented drugs. The company continuously
refreshes its product portfolio by developing new drugs directly or through joint
ventures. This is very important for the company to sustain high growth year after year.
 LAB Pharmaceuticals has developed a drug, Davanrik, to treat both depression and
obesity.
 LAB had previously tried to get approval for one of its compounds but was unsuccessful.
So it had decided to partner with an established Pharmaceutical company to conduct
clinical trials.
 The licensing agreement would require Merck to conduct the clinical trials, market the
drug. Lab would earn via licensing fees - royalty on sales and milestone based payments.
 After the approval, the patent protection will last for about 10 years.


1.2 OBJECTIVE
Rich Kender, Vice President of Financial Evaluation & Analysis at Merck, was working with
his team to decide whether Merck should license Davanrik.

1.3 PROBLEM STATEMENT

Should Merck license the Davanrik? If yes, what should be the licensing fee? How sensitive is
this decision on future cash flows associated with various costs?

QT-3 Assignment Merck and Co Page 3

 2. ANALYSIS
2.1 Alternate course of Action
 License the drug
 Do not license the drug

QT-3 Assignment Merck and Co Page 4

 2.2 Decision Tree
1
Launch Revenue
0.85 680
Phase 3 success -250 680 1200 680
1
-200 680
0.1
Depression(Phase II) -270
0 -270
-40 537.5
0.15
Phase 3 fail
-270
-200 -270

1
Launch Revenue
0.75 25
Phase III success -100 25 345 25
1
-150 25
0.15 Don't launch
Weight loss -220
0 -220
-40 -36.25
0.25
Phase III fail
-220
-150 -220

1
Launch Revenue
0.7 1280
Dual(Phase III success) -400 1280 2250 1280
1
0.6 -500 1280
Phase I Success Don’t launch
-570
-30 43.3 0 -570

1
Launch Revenue
0.15 380
Depression(Phase III success) -250 380 1200 380
1
-500 380
0.05 Don’t launch
Dual -570
0 -570
-40 879.75
1
Launch Revenue
0.05 -325
License Weight loss(Phase III success) -100 -325 345 -325
1
0 13.98 -500 -325
Don’t launch
-570
0 -570

0.1
Phase III fail
-570
-500 -570

1 0.7
13.98 Fail
-70
-40 -70

0.4
Phase I fail
-30
-30 -30

Don’t License
0
0 0

QT-3 Assignment Merck and Co Page 5

 Since the EMV of the decision tree is positive, Merck should license Davanrik.

From consolidated income statement, we could calculate the retained earnings as a

percentage of income before taxes.
Retained earnings as a percentage of PBT =

This should be maintained for this deal as well. Hence the most Merck could pay as
licensing fee is = 37.84% of $ 13.98 million = $ 5.29 Million

2.3 Should Merck bid to license Davanrik?

As the expected monetary value for licensing the drug is positive ($ 13.98 million), Merck
should license Davanrik.

Probability Failure
Phase I 0.4
Phase II 0.42
Phase III Depression 0.009
Weight Loss 0.0225
Dual 0.003
0.85

Money at stake Expected value $ Million

Phase I 12
Phase II 46.8
Phase III 71.8
3.375
1.5
Total 135.475

From the table above, we could see that expected value for failure is $ 135 million. Also,
since the payments are to be made on basis of milestones, Merck would have the advantage
of pulling out on later stages if progress is not made. The chances of failure reduce
dramatically once the drug passes Phase II testing. So Merck will risk losing $ 70 million only.
Once the drug passes Phase II, the chances of success are very high and it would only
require additional investment of $ 65 million.

2.4 What is the expected value of licensing arrangement to LAB? (5% royalty
assumed)
The cash flows of LAB are :
1. $ 5 million initial licensing fee in Phase I ( irrespective of success of Phase 1)

QT-3 Assignment Merck and Co Page 6

 2. $ 2.5 million in Phase II (Probability of occurrence 0.6)
3. Phase III
a. $ 20 million if the drug cures only depression (Probability of occurrence 0.1)
b. $ 10 million for weight loss only (Probability of occurrence 0.15)
c. $ 40 million if drug cures both depression and weight loss (Probability of
occurrence 0.05)

Cash flows
What LAB expects ( $ millions)
Initialization 5 Formula
Phase I 1.5 .6*.25
Phase II Depression 1.2 .6*.1.*20
Weight
Loss 0.9 .6*.15*.10
Dual 1.2 .6*.05*.40
Total 9.8

Expected royalty to LAB

Gross cash
flows ($
millions) Royalty % Probability Expected
Depression independent 1200 5% 5.1 3.1
Weight Loss 345 5% 6.75 1.2
Depression –dual 1200 5% 0.45 0.3
Weight Loss – dual 245 5% 0.15 0.1
Dual only 2200 5% 2.1 2.4
Total 6.9

QT-3 Assignment Merck and Co Page 7

 2.5 How would your analysis change if the cost of launching Davanrik for
weight loss were $ 225 million instead of $ 100 million?
Decision tree for the new scenario is:
1
Launch Revenue
0.85 680
Phase 3 success -250 680 1200 680
1
-200 680
0.1
Depression(Phase II) -270
0 -270
-40 537.5
0.15
Phase 3 fail
-270
-200 -270

1
Launch Revenue
0.75 -100
Phase III success -225 -100 345 -100
1
-150 -100
0.15 Don't launch
Weight loss -220
0 -220
-40 -130
0.25
Phase III fail
-220
-150 -220

1
Launch Revenue
0.7 1280
Dual(Phase III success) -400 1280 2250 1280
1
0.6 -500 1280
Phase I Success Don’t launch
-570
-30 28.925 0 -570

1
Launch Revenue
0.15 380
Depression(Phase III success) -250 380 1200 380
1
-500 380
0.05 Don’t launch
Dual -570
0 -570
-40 873.5
1
Launch Revenue
0.05 -450
License Weight loss(Phase III success) -225 -450 345 -450
1
0 5.355 -500 -450
Don’t launch
-570
0 -570

0.1
Phase III fail
-570
-500 -570

1 0.7
5.355 Fail
-70
-40 -70

0.4
Phase I fail
-30
-30 -30

Don’t License
0
0 0

QT-3 Assignment Merck and Co Page 8

From the tree, we could see that launching weight loss when the launching fee is $ 225
million would lead to losses. However, net EMV of the decision tree is still positive. Hence
Merck should still license the drug.

Case (i) If Merck finds out the Davanrik can cure only weight loss after Phase II, it should not
proceed any further. Since the loss incurred ($ 70 million) will be less than the loss ($ 100
million) if the product is launched.

Case (ii) If Phase II indicates dual efficacy and Phase III results in efficacy for only weight loss,
then Merck should go still launch the product as it will result in lower losses ($ 450 million)
than abandoning the product ($ 540 million)

3. LIST OF REFERENCES

 Richard S.Ruback, “Merck & Company: Evaluating a Drug Licensing Opportunity.”

Harvard Business School Case 9-201-023 25 March, 2003.

QT-3 Assignment Merck and Co Page 9