Merck & Co Inc Case Study

Introduction:

Merck & Co., Inc. was a global research-driven pharmaceutical company that discovers, develops, manufactures and markets human and animal health products through itself and its joint ventures.  Merck also provide pharmaceutical benefit management services to its customers.  By 1995, Merck had launched 15 new products including its most popular drugs, Vasotec, Mevacor, Prinivil, and Pepcid.  However, the patents for these drugs would expire by 2002.  Once they expired, the sales of these drug would decline substantially as substitutes became available.  Therefore, Merck needed to develop new drugs or in this case license the drug for another pharmaceutical company to stay on the leading edge.  

LAB, a small pharmaceutical company, was seeking a larger pharmaceutical company like Merck to license its new drug – Davanrik.  Davanrik was mainly used to treat depression and obesity.  Once the drug was approved by the FDA, the potential return would be enormous.  However, LAB does not have the resources to design, administer, and fund the clinical testing, its manufacturing and its marketing.  Therefore, if Merck take the offer, it would responsible for the approval of Davanrik, its manufacture, and its marketing.  Merck would however pay LAB an initial fee, a loyalty on all sales, and make additional payments as Davanrik completed each stage of the approval process.  

Analysis:

To decide whether Merck should take the offer, we needed to analyze how Merck was able to achieve substantial returns to capital given the large costs and lengthy time to develop drug first.  We knew from the case that once Davanrik was approved by the FDA, it would bring substantial potential profits to the company.  According to the case, if the drug were approved only for the treatment of depression it could bring as much as $1.2 billion to Merck; if the drug were approved only for weight loss, it could bring $345 million to Merck; if the drug were approved for both, it could have a PV of $2.25 billion.  Even though the costs of three phases and launching were large, and the length time for Davanrik to be approved by the FDA was long, the return was enormous especially if the drug were approved for both indications.  

Knowing the potential return was not enough for Merck to make a decision.  We also need to know the price Merck should pay and the costs associate with the offer.  In order to examine the benefit and costs more clearly, we built a decision tree that shows cash flows and probabilities at all stages of the FDA approval process (Exhibit).  According to the decision tree we made, we calculated net cash inflow by adding present value of potential profits and subtracting all of costs for different scenarios.  Then, we calculated joint probability for each scenario by multiplying probabilities for three phases one by one.  Finally, the expected value of licensing Davanrik was equal to the summation of product of net cash inflow and joint probability for different scenarios.  Therefore, Merck should bid to license Davanrik when the bid price is less than or equal to $13.98 million (Exhibit).  

What’s more, it is always good to examine the costs associated with the offer alone, in this case we need to calculate the expected value of the licensing arrangement to LAB.  The licensing arrangement to LAB should include the initial payment and the additional payments after completing every clinical testing phase.  And we assume a 5% royalty fee on any cash flow that Merck receives from Davanrik after a successful launch.  Following the same process we did in previous, we get a value of $16.68 million (Exhibit).

The following include the formula we used and the calculation we did to come up with $16.68 million.  Expected payoff = (probability of success X payoff if successful) + (probability of failure X payoff if failed); therefore, we can calculate the expected value as 5+0.6(2.5)+0.6(0.1)20+0.6(0.15)10+0.6(0.05)40+0.6(0.1)0.85(1200)0.05+ 0.6(0.15)0.75(345)0.05+0.6(0.05)0.15(1200)0.05+0.6(0.05)0.05(345)0.05+0.6(0.05)0.7(2250)0.05=$16.68.

Last but not least, we need to consider other situations in our analysis such as how would it change our decision if the costs of launching Davanrik for weight loss were $225 million instead of $100 million as given in the case.  Based on the analysis we did before, if Davanrik were only approved for weight loss, it would cost $100 million to launch and would have a PV of $345 million. So the PV before phase II is $183.75 [(345-100) *0.75] million, which is enough for the cost of $150 million if pursuing phase III. However, if the cost of launching Davanrik for only weight loss were $225 million, the PV before phase II will be $90 million, which will not be sufficient to cover the the cost of $150 million if pursuing phase III. So in this scenario, no process of considering only weight loss will be shown in the decision tree.  This makes a loss of $3.0375 [(36.25-70) *15%*60%] million in present value at today’s point comparing to previous analysis. Also the net cash inflow will change to -$450 (345-225-500-40-30) million from -$325 million in the analysis before. This creates a loss of $0.19 [(100-225) *5%*5%*60%] million in present value at today’s point comparing to previous analysis. In total, the PV today is $10.75 (13.98-3.0375-0.19) million. Therefore, Merck should pay no more than $10.75 million if the cost of launching Davanrik for weight loss were $225 million.