Merck&Company

Main Issue

In 2000, Rich Kender, Vice President of Financial Evaluation and Analysis at Merck & Company was discussing the opportunity of investing in licensing, manufacturing and marketing of Davanrik, a drug originally developed to treat depression by LAB Pharmaceuticals. LAB proposed to sell the right of all the future profit made from the successful launch of Davanrik at the cost of an initial fee, royalty payments and additional payments as the drug completed each stage of the approval process. Merck & Company's organizational goal is to constantly refresh it's company's drug development portfolio and reach as many customers as possible during the patented time. So there was not only the potential of financial gain or quantitative aspect of the offer, but also the qualitative value which will be added by getting better positioning in the risky pharmaceuticals industry.

Presenting team analysis

The presenting team started out by giving a background about the industry and the companies. The main issue and financial terms were explained. However we feel that some of the assumptions such as Merck's flexibility to back out from building the plant in case of failure were not clearly mentioned. They failed to explain why Davanrik's market risk was lower than its stand alone risk. Discounted cash flow method which is the traditional financial tool for evaluating capital allocation was rejected without explanation. We can rationalize not using DCF for its inability to capture risk uncertainty. Passive investments such as stocks and bonds are good candidates to use DCF on. Once these investments are made investors cannot influence the cash flow generation. We agree that decision tree can be used to make preliminary judgment and real option analysis can be used to get more definitive answer. We think that sensitivity analysis and scenario analysis could have been useful since all inputs may change over time.

Merck's investment valuation

Decision tree approach: This approach is suitable for projects that do not have to be funded all at one time. The alternatives, probability of payoffs are identified using diagrams which are simple to understand and interpret with brief explanation giving important insights. It identifies managerial flexibility to reevaluate decisions using new information and then either invest additional funds or terminate the project.

Results of decision tree:

This analysis shows that the projects NPV as 13.37 million dollar. Our result is slightly different than the presenting team because of rounding. But both of our teams had positive NPV which suggest that the project should be accepted. The presenting team mentioned coefficient of variation as 18.07 for the expected value which should be the standard deviation. In order to explore other uncertainty we would recommend using scenario and sensitivity analysis since variations in the inputs can largely change the successive outputs. In sensitivity analysis base case situation is developed using the expected values of the input. "What if" questions are asked to capture NPV value change with change in unit sales or variable costs. In Scenario analysis worst-case and best-case scenarios are developed using probability distribution. We are confident from our research that decision trees combined with scenario analysis will give us more reliability of our estimate.

Recommendation: Based on the forecast and profitability suggested