Executive Summary

Statement of the Problem LAB Pharmaceuticals does not have enough capital to finance the testing of Davanrik, an antidepressant drugs that has potential side effects relating to obesity. LAB approaches Merck & Co., Inc. (Merck) and asks the company to license Davanrik, as well as funding the clinical testing. Merck must decide whether or not to bid to license Davanrik and if so, at what price.
Discussion
Merck is facing patent expiration problem because most of its popular drugs are going to expire by 2002. Patent expiration will lead to a substantial loss of sales. Therefore, Merck must develop new compounds quickly to refresh its portfolio and counter the loss of sales.
Licensing Davanrik with LAB would help Merck to save from two to ten years of the discovery stage because Davanrik has already passed this stage and is in the pre-clinical development stage now. The income statement shows that Merck has spent almost two billions dollars annually for the last three years on research and development of new compounds; in particular, Merck spent $2,068 million in 1999. By licensing Davanrik, Merck would be able to save this amount of money and a lot of time to replace the patent. Then, it will be able to re-enter the market and gain revenue quickly. A decision tree analysis was constructed to help valuing the drug licensing decision. The maximum bid price that Merck should offer LAB should be lower than or equal to the total expected value of the project, which is $14 million. The expected value of the licensing arrangement is calculated based on the probability of success and failure of each stage during the FDA approval process; but it is not the cash flows that Merck or LAB will receive in the future. Therefore, $14 million is the maximum bid price that Merck should offer to license Davanrik. Merck has available resources to complete the drug testing, to manufacture and to market the drug; so it has higher bargaining power than LAB and can bid at a lower price than $14 million.
According to Davanrik failure probability analysis, the overall failure is 85.45%, which looks very high. However, the failure probability of phase III is very low, only 3.5%. This means that if Davanrik passed the first two phases, it would be almost certainly approved by FDA. In the case that Davanrik failed, the total loss would be $70 million; and this amount is less than four percent of the two billions dollars that Merck spends each year on research and development. In other words, the risk to license the drug is worth taking and the reward is very substantial. This means other pharmaceutical companies would be interested in licensing with LAB, and Merck should not bid the price too low. LAB also benefits if it enter the licensing arrangement with Merck. Each phase has a positive expected value of milestone payment; and the total expected value of milestone payments to LAB is a positive $9.8 million (TN-5). This is a very good signal for LAB. Assume a 5% royalty fee on any cash flows that Merck receives from Davanrik, the total expected value of royalty payments to LAB would also have a positive value of $7.25 million (TN-6).
Recommendation
Merck should bid to license Davanrik at $12 million. This bid price is less than the $14 million expected value because Merck has high bargaining power; and it is also not too low to make Merck loose the competition. This decision is beneficial to both companies. Merck can save a lot of time and money in developing new drugs; it can then re-enter the market and gain revenue quickly. LAB’s royalty expected value is positive ($7.25 millions), and by licensing with Merck, LAB would be able to get the first FDA approval for its compound – Davanrik.

Exhibit TN-1 Decision Alternatives Phase I Testing for Safety | Phase IITesting for Efficiency | Phase IIITesting for Long Term Use | Success | Depression | Success | Failure | Weight Loss | Failure | | Dual: Depression & Weight Loss | | | Failure | | | | |
Source: Case writer analysis.

Exhibit TN-3Davanrik Failure Probability Phase | Fail Probability – Per Phase | Fail Probability - Total | I | 40% | 40.00% | II | 60% x 70% | 42.00% | Phase III failure Probability is 3.45%
Phase III failure Probability is 3.45%
III – Depression | 60% x 10% x 15% | 0.90% | III – Weight Loss | 60% x 15% x 25% | 2.25% | III – Dual Indication | 60% x 5% x 10% | 0.30% | Total | | 85.45% |
Source: Company documents and case writer estimates.

Exhibit TN-2Decision Tree Analysis

%($30)
60%
40% ($0)
10%
15%
5%
70% ($0)
85%
15% ($0)
75%
25% ($0)
70%

15%
5%
Launch: Depression
Launch: Weight Loss
Launch: Dual Claim
Launch: Depression
Launch: Weight Loss
($40)

($200)
($150)
($500)

10% ($0)

($250)
($100)
($400)
($250)
($100)
($0)
$1,200
$1,200
$345
$345
$2,250
Phase I Success
Phase I Failure
Phase II Failure
Phase III Failure
Phase III Failure
Phase III Failure
In-License
Do Not License
Pursue Depression
Pursue Dual
Pursue Weight Loss
Phase III Success
Phase III Success
Phase III Success
Phase III Success
Phase III Success

($70)

$680 5.1% $34.7

($270)
0.90%
$25 6.75% $1.7

($220) 2.25% ($5.0)

$380 0.45% $1.7 ($30) 0.4% ($12.0)
42%
$1,280 2.1% $26.9

($325) 0.15% ($0.5) ($570) 0.3% ($1.7)

($2.4)

($29.4)

$14.0
CF
Prob %
EV
Source: Adapted from company documents, case writer estimates.

($30)
60%
40% ($0)
10%
15%
5%
70% ($0)
85%
15% ($0)
75%
25% ($0)
70%

15%
5%
Launch: Depression
Launch: Weight Loss
Launch: Dual Claim
Launch: Depression
Launch: Weight Loss
($40)

($200)
($150)
($500)

10% ($0)

($250)
($100)
($400)
($250)
($100)
($0)
$1,200
$1,200
$345
$345
$2,250
Phase I Success
Phase I Failure
Phase II Failure
Phase III Failure
Phase III Failure
Phase III Failure
In-License
Do Not License
Pursue Depression
Pursue Dual
Pursue Weight Loss
Phase III Success
Phase III Success
Phase III Success
Phase III Success
Phase III Success

($70)

$680 5.1% $34.7

($270)
0.90%
$25 6.75% $1.7

($220) 2.25% ($5.0)

$380 0.45% $1.7 ($30) 0.4% ($12.0)
42%
$1,280 2.1% $26.9

($325) 0.15% ($0.5) ($570) 0.3% ($1.7)

($2.4)

($29.4)

$14.0
CF
Prob %
EV
Source: Adapted from company documents, case writer estimates.

Exhibit TN-4: Decision Tree Assuming a $225 Million Weight Loss Launch Cost

($30)
60%
40% ($0)
10%
15%
5%
70% ($0)
85%
15% ($0)
75%
25% ($0)
70%

15%
5%
Launch: Depression
Launch: Weight Loss
Launch: Dual Claim
Launch: Depression
Launch: Weight Loss
($40)

($200)
($150)
($500)

10% ($0)

($250)
($225)
($400)
($250)
($225)
($0)
$1,200
$1,200
$345
$345
$2,250
Phase I Success
Phase I Failure
Phase II Failure
Phase III Failure
Phase III Failure
Phase III Failure
In-License
Do Not License
Pursue Depression
Pursue Dual
Pursue Weight Loss
Phase III Success
Phase III Success
Phase III Success
Phase III Success
Phase III Success

($70)

$680 5.1% $34.7

($270)
0.90%
($100) 6.75% ($6.75)

($220) 2.25% ($4.95)

$380 0.45% $1.71
($30) 0.4% ($12)
42%
$1,280 2.1% $26.9

($450) 0.15% ($0.68)
($570) 0.3% ($1.71)

($2.4)

($29.4)

$5.42
CF
Prob %
EV
Source: Adapted from company documents, case writer estimates.

($30)
60%
40% ($0)
10%
15%
5%
70% ($0)
85%
15% ($0)
75%
25% ($0)
70%

15%
5%
Launch: Depression
Launch: Weight Loss
Launch: Dual Claim
Launch: Depression
Launch: Weight Loss
($40)

($200)
($150)
($500)

10% ($0)

($250)
($225)
($400)
($250)
($225)
($0)
$1,200
$1,200
$345
$345
$2,250
Phase I Success
Phase I Failure
Phase II Failure
Phase III Failure
Phase III Failure
Phase III Failure
In-License
Do Not License
Pursue Depression
Pursue Dual
Pursue Weight Loss
Phase III Success
Phase III Success
Phase III Success
Phase III Success
Phase III Success

($70)

$680 5.1% $34.7

($270)
0.90%
($100) 6.75% ($6.75)

($220) 2.25% ($4.95)

$380 0.45% $1.71
($30) 0.4% ($12)
42%
$1,280 2.1% $26.9

($450) 0.15% ($0.68)
($570) 0.3% ($1.71)

($2.4)

($29.4)

$5.42
CF
Prob %
EV
Source: Adapted from company documents, case writer estimates.

Source: Adapted from company documents, case writer estimates.
Source: Adapted from company documents, case writer estimates.

Exhibit TN-5Expected Value (EV) of Milestone Payments to LAB (millions of dollars) | Milestone Payment(millions) | Probability | Milestone Payment EV(millions) | | | | | Initial | $5 | 100% | $5 | Phase I Success | $2.5 | 60% | $1.5 | Phase II Depression | $20.0 | 60% x 10% | $1.2 | Phase II Weight Loss | $10.0 | 60% x 15% | $0.9 | Phase II Dual Indication | $40.0 | 60% x 5% | $1.2 | | | | $9.8 |
Source: Case writer estimates.

Exhibit TN-6Expected Value (EV) of Royalty Payments to LAB | Gross CFa | Royalty Percent | Probability | Royalty EV | | (millions) | | | (millions) | Depression – Independent Claim | $1,263 | 5% | 5.10% | $3.22 | Weight Loss – Independent Claim | 363 | 5% | 6.75% | 1.23 | Depression – Dual Claim | 1,263 | 5% | 0.45% | 0.28 | Weight Loss – Dual Claim | 363 | 5% | 0.15% | 0.03 | Dual Claim | 2,368 | 5% | 2.10% | 2.49 | | | | 14.55% | $7.25 | | | | | |
Source: Case writer estimates. aMerck’s cash flow, net of royalty payments, is grossed up by 5%.