Merck & Company: Evaluating A Drug Licensing Opportunity

Should Merck license the compound?

Merck would be responsible for

1) the approval of Davanrik

2) the manufacture of Danavrik

3) marketing of Danavrik

Merck would pay LAB for

1) initial fee

2) royalty on all sales

3) make additional pymts as Danavrik completed each stage of approval process (3 Phases)

Additional facts:

approval process should take 7 years

patent will cover 17 years (7 of approval process nad 10 yr period of exclusivity beginning in yr 7)

1 Assumptions:

All Cash flows are expressed as after tax present values discounted to time zero, including capital expenditures

At any point "failure," investment decision is to stop funding

Assuming Standard deviation of 0.5

Using T= 7 years in Black-Scholes Valuation

2 Decision Tree

See worksheet "Decision Tree"

3 Detailed description of Real Option Technique

"First, using a decision tree, I came up with a simple expected value of $13,980,000 based on the costs to complete each phase, the probabilities of completing each phase, and the costs and probabilities associated with failure at each step in the approval process. The expected value of successful completion with Depression only was $36,390,000, for weight only $1,200,000 and for both $26,880,000. The expected value of failure (including failure at any phase) was ($59,490,000).

Next, I calculated the Valuations of each successful outcome using the decision tree analysis and the spectrum of outcomes with an asymetric distribution of rewards. Using the probability of 14.55%, which is the combined probability for any sucess, I recalculated the valuations of each success (Depression only, Depression only after testing for both in phase III, Weight only, etc). This gave me some drastically different valuations for those outcomes that had very small probabilities to begin with and ended with a summed expected value for the project of ($6,120,000). See the table below. "

"When using the Black-Scholes spreadsheet to calculate the valuations, I used the 14.55% (as was done in the lecture slide notes). I have listed out the differences between the black-scholes model valuations and the decision tree analysis results below.

I also attempted some sensitivity analysis by changing the standard deviation within the range 0.4 and 0.6 and found that the results were extremely sensitive to the change in volatility."

Simple Expected Value Decision Tree Analysis Valuation Black Scholes Model (Sigma= .5) Black Scholes Model (Sigma= .4) Black Scholes Model (Sigma= .6)

Dep alone $34,680,000.00 $48,450,000.00 $57,183,065.00 $35,298,491.00 $79,271,963.00

Dep Both $1,710,000.00 $4,800,000.00 $37,946,960.00 $18,883,685.00 $59,659,834.00

Weigh Alone $1,687,500.00 $(46,852,500.00) $9,078,380.76 $3,945,847.00 $15,426,873.00

Weight Both $(487,500.00) $(97,777,500.00) $3,625,879.00 $940,463.00 $8,247,272.00

Both $26,880,000.00 $64,470,000.00 $102,770,810.00 $62,897,776.00 $143,194,146.00

Failure $(50,490,000.00)

4 Brief one paragraph summary of the Issues you are analyzing

We are trying to determine whether Merck should take on the responsibility of funding LAB Pharmaceuticals in the testing, marketing, and maufacturing of the new drug, Davanrik, by utilizing Real Options techniques. Merck would be responsible for paying the initial fee, the royalties on all sales and make additional payments as Danavrik completed each stage of approval process. The approval process should take 7 years and the patent will cover 17 years (10 years of exclusivity beginning in year 7). Merck determined the probabilities of success in each of the three phases and also the costs that would be associated with each phase based on historical information. One of the concerns is that LAB Pharmaceuticals has never successfully completed all three phases. Merck must look at the probabilities of success and the costs associated and then determine if they would like to accept LAB's offer and for what price they would be willing to pay for this option. The drug Davanrik has potential to help with depression and/or obesity.