FINANCE-II

EXECUTIVE SUMMARY
Merck and Co., Inc. is a global research-driven pharmaceutical company that discovers, develops, manufactures and markets a broad range of human and health products, directly and through its joint ventures, and provides pharmaceutical benefit management services (PBM) through Merck-Medco Managed Care. The company earned $5.9 billion on 1999 sales of $32.7 billion about a 20% increase from 1998. The company s most popular drugs-Vasotec, Mevacor, Prinivil & Pepcid generated revenues worth $5.7 billion but the patents for them were due to expire in 2002. The company needed to innovate and add new products to the portfolio to maintain its position in the market. They had their own laboratories where research was carried to develop new products and they also purchased licenses from smaller firms working on certain drugs. LAB Pharmaceuticals was one such firm which was offering to license its drug Davanrik to Merck. Davanrik was currently in the pre-clinical development stage and LAB being a small company could not afford to get it through the FDA approval process. They were ready to give the rights to Merck on the condition that Merck would pay it an initial fee, take the drug through the entire FDA approval stage, manufacture the compound, market the drug and pay a royalty on all sales. Merck was also supposed to pay a certain fee on completion of every stage of approval. Davanrik was originally developed to treat depression. However it was later realised that it also affected the hunger of the person and could be used as a drug for obesity patients. In Phase 1 of the clinical approval stage, the drug is given to 20-80 volunteers to test for safety. This phase would take 2 years. If Merck decided to go ahead with the first phase it would have to invest $30 million including an initial $5 million fee to LAB for licensing the drug. There was a 60% chance that Davanrik would successfully complete Phase 1.

In Phase 2, a larger number (100-300) of patient volunteers are tested to determine if the drug is effective or not and also, any side-effects are checked for. To get through this stage, Davanrik would have to demonstrate a statistically significant impact on patients suffering from depression, obesity or both. Because of the tough regulations, probability of passing this phase were significantly low. The Merck team estimated a 10% probability that Phase 2 would show that Davanrik would be effective for depression only, 15% probability for weight loss only, and a 5% probability for both depression and weight loss. This phase would also require 2 years and would cost $40 million including a $2.5 million licensing milestone payment to LAB. In Phase 3, 1000-5000 volunteers are tested for safety and efficacy in long term use. Chances of success and cost in this phase depended on the outcome from Phase 2. If Davanrik was effective for only depression, Phase 3 trials would cost $200 million including a $20 million payment to LAB, and have an 85% chance of success. If it were effective for weight loss only, it would cost $150 million (including a $10 million payment to LAB) and have a 75% chance of success. If however, it was efficacious for both weight loss and depression, more specialized trials would be required to determine efficacy for the dual indication. The total cost of the Phase 3 clinical tests for the two separate indications together with the dual indication was expected to be $500 million (including a $40 million licensing payment to LAB) and had a 70% chance of successful outcome. Under this scenario, there was a 15% chance of a successful outcome for depression only, and a 5% chance of a successful outcome for weight loss only. The probability of complete failure of the dual indications or either separate indication was only 10%. If the drug were approved only for the treatment of depression, it would cost $250 million to launch, and had a commercialization present value of $1.2 billion. If Davanrik were only approved for weight loss, it would cost $100 million to launch, and would have a present value of $345 million. If it were approved for both, it would cost $400 million to launch and have a present value of $2.25 billion. Rick Kender, the Vice President of Financial Evaluation and Analysis at Merck, with his team, needs to decide whether his company should license Davanrik or not. The basis for taking this decision has to be on the basis of a detailed cash flow analysis of the entire problem. We can take help of the decision tree analysis to see what are the various cash flows involved and their effect on the final decision based on the probability of such an event taking place.

Decision Tree is as given below:

As we can see that the total expected cash flow from investment in Davanrik is $ 14 million. This seems to be a significant value so we should go ahead and invest in this drug. But at the same time we need to remember that we are also supposed to pay royalty to LAB for the cash flows we generate from the sales of Davanrik. So what is the maximum Royalty we can pay?

After analysis the cash effect of various percentages of royalty, we have concluded that Merck can afford to pay a maximum royalty of 10% and still remain in positive We also need to consider Merck s need for new drugs in this case. As most of their drugs will soon lose their patents, this investment can help them to continue having a unique market of their own. We have come to a conclusion that Merck should invest in this drug due to economic reasons also also for better future prospects.

DETAILED CASE ANALYSIS

PROBLEM
Merck needs to decide whether to invest in Davanrik or not as there are high chances that the drug may not be approved. They also need to decide how much royalty to offer to LAB

ALTERNATIVES
Here the alternatives are limited. There are only two alternatives that are present in front of Merck, either to go for the drug or not to go for it. The amount of Royalty that they have to give to LAB depends on what they demand but we can see how much they can pay at maximum

CRITERIA

A Decision tree analysis of the entire situation has been done. All the cash flows have been taken into account and in their present value. We also need to look at the qualitative angle of this investment i.e. Do Merck need this drug and what will be the benefits they derive from investing in it We have done a cost analysis of various royalty values and seen their effect on total cash flow to decide how much royalty they can afford to pay

EVALUATION
As we can see in the decision tree which has been seen earlier, the net expected value of investment in Davanrik is $14 million. This value has been reached at after considering the risk involved in the drug i.e. the drug may actually not get approved through any one of the phases that are required to be passed. But in actual, the cash flows will be very higher as if the drug actually gets approved then all the income above the costs will be profit but at the same time it is possible that the drug may fail at any one of the phases and all the cost incurred in the tests will be a loss. In this case there is a very high probability i.e. 70% of the product failing in the 2 phase
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If we look at the problem qualitatively, Merck is in big need to develop new products as their current big sellers will soon lose their patents and the company will face huge competition in the market and it needs to introduce new products in the market to retain its position in the industry. Hence, it is of strategic importance to Merck to invest in this drug and as we can see in the decision tree analysis also, if the drug passes the tests, it will be a huge cash flow generator. If we do the analysis of royalty that Merck will have to pay to LAB when the product is introduced in the market, we get the following results,

As we can see here, the maximum royalty that we can afford to pay is 10 %

SOLUTION
Merck should go ahead and invest in Devanrik as the net expected value is very high and also, if successful it will generate huge cash. But this decision depends on the demand of royalty by LAB. Though theoretically we can offer royalty upto 10%. But that is something that we may not worry about very much as that comes into play only if the drug is successful. Also, Because most of Merck s drugs will soon lose their patents, its important for them to invest in Davanrik as if successful, they will have a unique product in the market.