Background Knowledge

Net Present Value - present value of future cash flows, discounted at appropriate interest rate, minus the present
value of the cost of investment. An investment is worth making if NPV is positive, otherwise it should be
rejected.
NPV = - cost + PV
Decision Tree it breaks complex business into components by setting out key decisions as a series of yes or
no decision forks and subsequent random outcomes as additional forks with probabilities.
Decision tree analysis - Widely used technique to determine value of investments under uncertainty
Main steps:
Determine possible states of nature
Determine probability of reaching each state
Determine NPV for each end state
Expected NPV/payoff for each outcome is the NPV multiplied by the probability of that fork.
Expected NPV of experiment is expected NPV for the decision forks times the probabilities of the experimental
outcomes
Choose the highest expected NPV branch at decision forks

Case Brief
The case talks about Merck & Co., Inc., which was a global-research driven company and is trying to
bid for a license to develop a drug from another company. Since 1995, the company has launched 15 new
products and the earning of the company are $5.9 billion on 1999 sales of $32.7 billion, about a 20% increase
from 1998. Only few of the brands under Merck & Co. were responsible for a large chunk of the revenue. The
patents of these drugs were about to expire in a few years. It was widely believed that once the patent on these
drugs expire, they would be generation very less revenue as compared to the present amount. Thus, they need to
come up with new products every now and then. To do so, they invest heavily on research and development (R
& D) activities. These activities will ensure that Merck & Co. has a constant stream of income being generated
from its sales of patented drugs.
LAB Pharmaceuticals was a company which developed a drug called Davanrik which was used to treat
depression. It seemed not only to stimulate the receptor that promotes antidepression, but also to block the
receptor that causes hunger. LAB has approached Merck with an offer to license the compound which would
make Merck & Co. responsible for the approval of Davanrik, its manufacture and its marketing. The return for
LAB Pharmaceuticals is that it would get an initial fee, a royalty on all the sales and make additional payments
as Davanrik completed each stage of the approval process.
At the time of LABs offer, Davanrik was in pre-clinical development, ready to enter the three-phase
clinical approval process required for pharmaceuticals in United States. While the company is 15 years old and
had a few drugs in Phase II and Phase III testing, none had successfully completed FDA approval process.
Recently, FDA had rejected one of its drugs which passed all the stages of the tests. This made their stock fall
30% and thus, they could not get more capital to invest through the equity route. By collaborating with Merck &
Co., it can easily generate lots of revenue.
Merck & Co. needs to decide that whether it should go for this collaboration and if yes, what should be
the correct value. Overall, the approval process was expected to consume about seven years. LAB had obtained

a patent on the product, which is estimated to have a remaining life, including all possible extensions, of 17
years. Therefore, the product would have a 10-year period of exclusivity, beginning in 7 years.

Problems Identified
In the given case the company must decide on a plan of action based on a number of possibilities. In order to
come to a decision to license Davanrik or not Merck must carefully analyze the various possibilities in the
project. Since at each step a decision has to be made and there is a probability of following a particular path, a
decision tree can be used to help solve the problem. The tree would give a clear picture of the various options
available at each step and by calculating the NPV at each decision stage starting from the last and moving to the
first we can estimate whether Merck should license Davanrik or not.

Detailed Analysis
Q1. How has Merck been able to achieve substantial returns to capital given the large and lengthy time to
develop drugs?

Solution:
As can be seen from the case facts, a handful of Mercks popular drugs, namely, Vasotec, Mevacor,
Prinivil, and Pepcid generated $5.7 billion in worldwide sales. This was primarily due to the patents on these
drugs. Once the patents expire, the sales of the drugs decline substantially due the availability of generic
substitutes that are a lot cheaper. The only way out for Merck to counter the loss in sales from the drugs going
off patent was to constantly refresh the companys portfolio. The company develops new compounds primarily
through internal research, but complement this through initiatives with biotechnology companies to ensure
Merck is on the leading edge of select therapeutic categories. This is how Merck has been able to achieve
substantial returns on capital.

Q2. Build a decision tree that shows the cash flows and probabilities at all stages of the approval process.

Success (0.85)
NPV = $680
mn
Phase III

Depression Only
(0.1)

Cost = $200
Failure (0.15)
mn
NPV = -$270
Success
mn
(0.75)
Obesity Only
(0.15)

NPV = $25
Phase III
mn
Cost = $150
Failure (0.25)
mn
NPV =(0.7)
-$220
Success
mn

Success
(0.6)
Ye
s

Phase I:

Phase II
Cost = $40
mn
Both (0.05)

Cost = $30 mn

License
?

Failure (0.4)

No

NPV = -$30
mn

NPV = $1280 mn
Depression Only
(0.15)
Phase III
Cost = $500
mn

NPV = $380 mn
Obesity Only
(0.05)
NPV = - $325mn

Failure (0.7)
None (0.10)
NPV= -$70Mn
NPV = -$570 mn

Q3. Should Merck bid to license Davanrik? How much should they pay?
Solution:
Expected NPV of the project is calculated by taking product of the estimated NPV of a particular case and its
corresponding probability of occurrence. As the expected NPV of this project is found to be $ 13.98 million
which is positive, the project should be accepted. Merck should bid to license Davanrik.
The payment to LAB should be done in such a manner that it should not exceed the expected NPV. In case
Merck agrees to pay LAB the amount equal to expected NPV, they will not make any profit on this project.
Therefore, total payments to LAB should be kept below $13.98 million mark. The exact amount should be
finalized as per the policy of the organization and in accordance with the return that Merck want from this
project.
Q4. What is the expected value of the licensing arrangement to LAB? Assume a 5% royalty fee for any cash
flows that Merck receives from Devanrik after a successful launch.
Solution:
Expected value of the licensing arrangement to LAB will be the total of expected value of licensing
fee and expected value of the royalty received by sales of drug if the FDA approval is granted.

Expected values of licensing fee and royalty can be calculated by multiplying amount of licensing fee
and royalty with its corresponding probability.
The following values were found:
E (Licensing Fee)= $ 6.09 million
E (Royalty)=$ 6.875 million
Therefore,
E (Licensing Arrangement) = E (Licensing Fee) + E (Royalty)
= $ 12.965 million
Q5. How would your analysis change if the cost of launching Davanrik for weight loss were $225 million
instead of $100 million as given in the case?
Solution:
To analyze the affect of this change we will have to calculate the expected NPV of the project again.
Due to increase in cost of launching the NPV of success for obesity treatment will reduce to -$100 million from
initial value of $25 million. Similarly, the NPV of launching of this drug after failure of Phase III for both uses
will go further negative to -$450 million from the initial value equal to -$325 million. These changes will reduce
the Expected NPV of the complete project from $13.98 million to $5.355 million.

Recommendations
According to the analysis performed above we would recommend Merck & Co. to bid for the Davanrik drug
because the Net Present Value (NPV) is positive. The only concern is the riskiness of the project. The new drug
has to pass the three phase test procedure before it is launched and commercialized. But there are only 0.3
probabilities that the drug would cross Phase II of the testing process and hence has a very high probability of
failing in Phase II only. We believe that Merck and Co. should not pay the licensing fee to LAB pharmaceuticals
until the drug is successfully tested and launched. Once the launch is successful Merck & Co. can pay a lump
sum amount as license fee to LAB Pharmaceuticals and can continue paying royalty fees as and when it realizes
the revenues. By doing this they would reduce their costs incurred during the risky testing procedure. Also the
entire testing process runs for approximately 7 years and would have an exclusive life of 10 years due to the
patent; hence the time involved is also quite high. Therefore by reducing the entire risk of the project they can
reap good amount of returns on the project.

Conclusion
The case involves the use of a decision tree approach to evaluate various outcomes of a project and the NPV
analysis of such a project. This approach takes care of the uncertainties involved in the NPV analysis regarding
the future cash flows of a project. Each cash flow is associated with a probability and using these probabilities
the NPV is calculated for the project on which the capital budgeting decision is based.