Risk

Based Investment Decision

Case: Merck & Company:
Evalua<ng a Drug Licensing
Opportunity

1

Depression
Davanrik

Weight Loss
Depression &
Weight Loss
5

Merck

Discovers

Develops

Manufactures

Markets

Broad range
human and
animal health
products

Directly
Through joint ventures
Providing pharmaceu9cal benet
management services (PBM) through
Merck-Medco Managed care
6

Design

Marke<ng

Administer

Role of
licensee

Manufacturing

Fund the
clinical tes<ng
of the
compound
7

Lab

Davanrik

Ini9al fee
Responsible for the approval of Davanrik, its manufacture,
and its marke9ng
Royalty on all sales

Merck

Responsible for the approval of Davanrik, its manufacture, and

its marke9ng
Senior researchers: evaluated scien9c aspects of the compound
Marketers: evaluate market size, poten9al compe99on, and
requirements to successfully launch the drug
Manufacturing manager: determine the capital required to
produce the drug
Financial experts: nancial analysis of licensing decision

Compound Success

COMPOUND SUCCESS RATES BY STAGES

Rates by Stage
5,000-10,000
screened

Discovery
(2-10 Years)

250
enter preclinical testing

Preclinical Testing
Laboratory and animal testing

5
enter clinical testing

Phase I
20-80 healthy volunteers used to
determine safety and dosage

Phase II
100-300 patient volunteers used
to look for efficacy and side effects

Phase III
1,000-5,000 patient volunteers used to monitor
adverse reactions to long-term use .

FDA Review/
Approval
Additional
Post-marketing Testing

10

12

14

16

Approved by the FDA

9

Years

Phase I

Phase II
(clinical tes<ng)

Phase III

Tested on

20-80 healthy 100-300

volunteers
of pa<ent volunteers

1000-5000 of
pa<ents

Tested for

Safety

Eec<veness
Poten<al side eect

Safety and ecacy

in long-term use

Time taken

2 years

2 years

3 years

Cost

$30 million

$40 million

Depression: 200 mn
Weight loss: $150 mn
Both: $500 mn

Ini<al fee /
Milestone
fee to LAB

$5 million

$2.5 million

Depression: 20 mn
Weight loss: $10 mn
Both: $40 mn
10

Probability of Success
Phase I

Chance of success

60%

Phase II
(clinical tes<ng)

Phase III

Depression: 10%
Weight loss: 15%
Both: 5%

Depression: 85%
Weight loss: 75%
Both: 70%

Depression: 15%
Weight loss: 5%
Both: 10%

Cash Flows
Depression only

Weight loss only

Both

Cost to launch

$250 million

$100 million

$400 million

Commercializa<on
present value

$1.2 billion

$345 million

$2.25 billion

All cash flows are expressed as after-tax present values discounted to time zero, including capital
expenditures
Present value is calculated as the after-tax present value of 10 years worth of cash flows from the
drug discounted back to today
It was believed that after 10 years, the drug had very little value to the company since it would be off
11
its patent by then (and thus a terminal value of zero was used in the calculations)

12

Possible Outcome
Phase II
Depression
Phase I Success

Phase II
Weight Loss

In-License

Phase III
Success
Phase III
Failure
Phase III
Success
Phase III
Failure
Phase III
Success Both

Davanrik

Phase I Failure

Phase II Both

Do not License
Phase II Failure

Phase III
Success
Depression
Phase III
Success
Weight Loss
Phase III
Failure
13

Probability

Phase II
Depression
10%
Phase I Success
60%

Phase II Weight
Loss
15%

In-License

Phase I Failure
40%

Davanrik

Phase III Success

85%
Phase III Failure
15%
Phase III Success
75%
Phase III Failure
25%
Phase III Success
Both
70%

Phase II Both
5%

Do not License
Phase II Failure
70%

Phase III Success

Depression
15%
Phase III Success
Weight Loss
5%
Phase III Failure
10%
14

15

Cash Ou_low
Phase II Depression
10%
-$ 200 mn
Phase I Success
60%
-40 mn

Phase II Weight Loss

15%
-$150 mn

In-License
-$30 mn

Phase I Failure
40%
-$0

Davanrik

Phase III Success

85%
-$250 mn

Phase III Failure

15%
-$0

Phase III Success

75%
-$100 mn

Phase III Failure

25%
-$0

Phase III Success Both

70%
-$400 mn
Phase II Both
5%
-$500 mn

Do not License
-$0
Phase II Failure
70%
-$0

Phase III Success

Depression
15%
-$250 mn
Phase III Success Weight
Loss
5%
-$100 mn
Phase III Failure
10%
-$0

17

Commercial Value
Phase II Depression
10%
-$ 200 mn
Phase I Success
60%
-40 mn

Phase II Weight Loss

15%
-$150 mn

In-License
-$30 mn

Phase I Failure
40%
-$0

Davanrik

Phase II Both
5%
-$500 mn

Do not License
-$0
Phase II Failure
70%
-$0

Phase III Success

85%
-$250 mn

$1200 mn

Phase III Failure

15%
-$0

Phase III Success

75%
-$100 mn

$345 mn

Phase III Failure

25%
-$0

Phase III Success Both

70%
-$400 mn

$2250 mn

Phase III Success

Depression
15%
-$250 mn

$1200 mn

Phase III Success Weight

Loss
5%
-$100 mn

$345 mn

Phase III Failure

10%
-$0

Failure
Probability
Phase II Depression
10%
-$ 200 mn
Phase I Success
60%
-40 mn

Phase II Weight Loss

15%
-$150 mn

In-License
-$30 mn

Phase I Failure
40%
-$0

Davanrik

Do not License
-$0

Phase III Success

85%
-$250 mn

Phase III Failure

15%
-$0

0.90%

Phase III Success

75%
-$100 mn

Phase III Failure

25%
-$0

2.25%

Phase III Success Both

70%
-$400 mn
Phase II Both
5%
-$500 mn

40%
Phase II Failure
70%
-$0

42%

Phase III Success

Depression
15%
-$250 mn
Phase III Success Weight
Loss
5%
-$100 mn

Phase III Failure

10%
-$0

0.30%

Total: 85.45%

Success
Probability

6%
60%
Phase I Success
60%
-40 mn

Phase II Depression
10%
-$ 200 mn

9%
Phase II Weight Loss
15%
-$150 mn

In-License
-$30 mn

3%
Phase I Failure
40%
-$0

Davanrik

Phase II Both
5%
-$500 mn

Do not License
-$0
Phase II Failure
70%
-$0

Phase III Success

85%
-$250 mn

5.10%

Phase III Failure

15%
-$0

Phase III Success

75%
-$100 mn

6.75%

Phase III Failure

25%
-$0

Phase III Success Both

70%
-$400 mn

2.10%

Phase III Success

Depression
15%
-$250 mn

0.45%

Phase III Success Weight

Loss
5%
-$100 mn

0.15%

Phase III Failure

10%
-$0

Total: 92.55%

Total Possible
Probability
Phase II Depression
10%
-$ 200 mn
Phase I Success
60%
-40 mn

Phase II Weight Loss

15%
-$150 mn

In-License
-$30 mn

Phase I Failure
40%
-$0

Davanrik

Phase II Both
5%
-$500 mn

Do not License
-$0

40%

Phase II Failure
70%
-$0

42%

Phase III Success

85%
-$250 mn

5.10%

Phase III Failure

15%
-$0

0.90%

Phase III Success

75%
-$100 mn

6.75%

Phase III Failure

25%
-$0

2.25%

Phase III Success Both

70%
-$400 mn

2.10%

Phase III Success

Depression
15%
-$250 mn

0.45%

Phase III Success Weight

Loss
5%
-$100 mn

0.15%

Phase III Failure

10%
-$0

0.30%
Total: 10%

Cash Flow
Outcome
Phase II Depression
10%
-$ 200 mn
Phase I Success
60%
-40 mn

Phase II Weight Loss

15%
-$150 mn

In-License
-$30 mn

Phase I Failure
40%
-$0

Davanrik

Phase II Both
5%
-$500 mn

Do not License
-$0

-$30 mn

Phase II Failure
70%
-$0

-$70 mn

Phase III Success

85%
-$250 mn

$680 mn

Phase III Failure

15%
-$0

-$270 mn

Phase III Success

75%
-$100 mn

$25 mn

Phase III Failure

25%
-$0

-$220 mn

Phase III Success Both

70%
-$400 mn

$1280 mn

Phase III Success

Depression
15%
-$250 mn

$380 mn

Phase III Success Weight

Loss
5%
-$100 mn

-325 mn

Phase III Failure

10%
-$0

-570 mn

Expected Cash Flow

Phase II Depression
10%
-$ 200 mn
Phase I Success
60%
-40 mn

Phase II Weight Loss

15%
-$150 mn

In-License
-$30 mn

5.10%*$680 mn = $34.7 mn

Phase III Failure

15%
-$0

0.90%*-$270 mn = -$2.4 mn

Phase III Success

75%
-$100 mn

6.75%*$25 mn = $1.7 mn

Phase III Failure

25%
-$0

2.25%*-$220 mn = -$5 mn

Phase III Success Both

70%
-$400 mn

Phase I Failure
40%
-$0

Davanrik

Phase III Success

85%
-$250 mn

Phase II Both
5%
-$500 mn

Do not License
-$0
Phase II Failure
70%
-$0

40%*-$30 mn = -$12 mn

42%*-$70 mn = -$29.4 mn

Expected value = weighted average outcome, where

the weights are probabili9es of each state

2.10%*$1280 mn = $26.90 mn

Phase III Success

Depression
15%
-$250 mn

0.45%*$380 mn = $1.70 mn

Phase III Success Weight

Loss
5%
-$100 mn

0.15%*-$325 mn = -$0.5 mn

Phase III Failure

10%
-$0

0.30%*-370 mn = -$ 1.7 mn

Total: $14 mn

Expected Milestone
Payment
60% * $2.5 mn =
$1.5 mn

100% * $5mn =
$5mn

Phase I Success
60%
-40 mn

6%* $20 mn =
$1.2 mn
Phase II Depression
10%
-$ 200 mn

9% * $10 mn =
$0.9 mn
Phase II Weight Loss
15%
-$150 mn

In-License
-$30 mn

3% * $40 mn =
$1.2 mn
Phase I Failure
40%
-$0

Davanrik

Phase II Both
5%
-$500 mn

Do not License
-$0
Phase II Failure
70%
-$0

Phase III Success

85%
-$250 mn

Phase III Failure

15%
-$0

Phase III Success

75%
-$100 mn

Phase III Failure

25%
-$0

Phase III Success Both

70%
-$400 mn

Phase III Success

Depression
15%
-$250 mn
Phase III Success Weight
Loss
5%
-$100 mn

Phase III Failure

10%
-$0

Total: $9.8 mn

Expected Royalty
Payment
Phase II Depression
10%
-$ 200 mn
Phase I Success
60%
-40 mn

Phase II Weight Loss

15%
-$150 mn

In-License
-$30 mn

Phase I Failure
40%
-$0

Davanrik

Phase III Success

85%
-$250 mn

Phase III Failure

15%
-$0

Phase III Success

75%
-$100 mn

Do not License
-$0
Phase II Failure
70%
-$0

6.75% * $363 mn * 5% = $1.23 mn

Phase III Failure

25%
-$0

Phase III Success Both

70%
-$400 mn
Phase II Both
5%
-$500 mn

5.10% * $1263 mn *5% = $3.22 mn

0.15% * $2368 mn * 5% = $2.49 mn

Phase III Success

Depression
15%
-$250 mn

2.10% * $1263 * 5% = $0.28 mn

Phase III Success Weight

Loss
5%
-$100 mn

0.45% * $363 mn * 5% = $0.03 mn

Phase III Failure

10%
-$0

Total: $7.25 mn

Expected Value of Perfect

Informa9on (EVPI)

Phase II Depression
10%
-$ 200 mn
Phase I Success
60%
-40 mn

Phase II Weight Loss

15%
-$150 mn

In-License
-$30 mn

Phase I Failure
40%
-$0

Davanrik

Phase II Both
5%
-$500 mn

Do not License
-$0

-$30 mn +$12 mn =
-$18 mn

Phase II Failure
70%
-$0

-$70 mn +$29.4 mn =
-$40.6 mn

Phase III Success

85%
-$250 mn

$680 mn - $34.7 mn =
$645.3 mn

Phase III Failure

15%
-$0

-$270 mn +$2.4 mn = -$267.6

mn

Phase III Success

75%
-$100 mn

$25 mn - $1.7 mn = $23.3 mn

Phase III Failure

25%
-$0

-$220 mn +$5 mn = -$215mn

Phase III Success Both

70%
-$400 mn

$1280 mn - $26.90 mn =
$1253.1 mn

Phase III Success

Depression
15%
-$250 mn

$380 mn - $1.70 mn =
$378.3 mn

Phase III Success Weight

Loss
5%
-$100 mn

-$325 mn + $0.5 mn =
-$324.5 mn

Phase III Failure

10%
-$0

-370 mn +$ 1.7 mn =
-$368.3 mn

Expected value of perfect informa9on (EVPI) = measures the dierence, or the gain due to perfect informa9on
EVPI = measures the dierence between certain payo that could be realized under a condi9on of certainty and
the expected payo under a condi9on involving risk
EVPI = EPC EMV
26
EPC = expected payo under certainty

27

Non Risk Based

Non-Discoun9ng
Techniques

PBP
ARR
NPV

Non Risk Based

Discoun9ng
Techniques

CB Techniques

IRR
MIRR
PI
EA
Sensi<vity analysis
Scenario analysis
Certainty equivalent model

Risk Based
Techniques

Decision tree analysis

Dura<on
Simula<on
Risk adjusted discount rate
Real op<ons

Non risk based techniques assumes that all projects were to be equally risky, acceptance of any project would
not alter the firms overall risk
28