Merck & Company:

Evaluating a Drug Licensing Opportunity

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

0
Years

10

12

14

16

Approved by the FDA

13

Davanriks Potential
Cash Flows
Phase I

Phase II
(clinical testing)

Phase III

Tested on

20-80 healthy
volunteers

100-300
of patient volunteers

1000-5000 of
patients

Tested for

Safety

Effectiveness
Potential side effect

Safety and efficacy

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

Initial fee /
Milestone fee
to LAB

$5 million

$2.5 million

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

14

Davanriks Potential
Cash Flows
Phase I
Chance of
success

60%

Phase II
(clinical testing)

Phase III

Depression: 10% Depression: 85%

Weight loss: 15% Weight loss: 75%
Both: 5%
Both: 70%
Depression: 15%
Weight loss: 5%
Both: 10%

15

Davanriks Potential
Cash Flows
Depression only

Weight loss only

Both

Cost to launch

$250 million

$100 million

$400 million

Commercialization
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 its patent by then
(and thus a terminal value of zero was used in the calculations)

16

Value of Licensing to Merck

Source of compounds without risk, cost, and product
development time of the discovery phase
Marshal a compound through phase testing by levering
its expertise in the administrative and scientific
requirements of the FDA process
Bring the product to the market place rapidly, making
most of the limited time under patent protection

20

Value of Licensing to LAB

Cash flow in form of initial and milestone
payments and sales royalties
Focus on its competitive advantage and develop
new compounds because of expert support in
FDA approval

21

Decision Alternatives
Decision Alternatives
Phase I
(Safety)

Phase II
(Efficacy)

Phase III
(Long Term Use)

Success

Depression

Success

Failure

Weight loss

Failure

Both
Failure

23

Phase III: Success

Phase II: Depression
Phase III: Failure
Phase III: Success
Phase II: Weight Loss
Phase III: Failure
Phase I: Success

In-License

Phase II: Both

Phase III: Success

Both

Phase III: Success

Depression

Phase III: Success

Weight loss

Phase III: Failure

Phase II: Failure
Phase I: Failure

Do not License

Phase III: Success

Phase II: Depression
10%

85%
Phase III: Failure
15%
Phase III: Success

Phase II: Weight Loss

15%

Phase III: Failure

25%
Phase III: Success

Phase I: Success

Phase II: Both

5%

Phase III: Success

Phase II: Failure

40%
Do not License

70%

Depression

15%
Phase III: Success
5%
Phase III: Failure

Phase I: Failure

Both

70%

60%
In-License

75%

10%

Weight loss

Phase III: Success

85%

Phase II: Depression

10%

-$200

-$250

Phase III: Failure

15%
-$0
Phase III: Success
75%

Phase II: Weight Loss

15%

-$150

-$40

In-License

70%

5%

15%
-$500

Phase III: Success

Phase I: Failure
40%
Do not License
-$0

-$0

70%

10%
-$0

Depression

-$250

5%
-$100
Phase III: Failure
Phase II: Failure

Both

-$400

Phase III: Success

Phase II: Both

-$30

Phase III: Failure

25%
-$0
Phase III: Success

Phase I: Success
60%

-$100

-$0

Weight loss

Phase III: Success

85%

Phase II: Depression

10%

-$200

-$250

$1,200

Phase III: Failure

15%
-$0
Phase III: Success
75%

Phase II: Weight Loss

15%

-$150

-$40

In-License

70%

5%

-$30

-$400

Phase III: Success

Phase II: Both

15%
-$500

-$250

Phase III: Success

5%
-$100
Phase III: Failure

Phase II: Failure

Phase I: Failure
40%
Do not License
-$0

-$0

70%

10%
-$0

$345

Phase III: Failure

25%
-$0
Phase III: Success

Phase I: Success
60%

-$100

-$0

Both
$2,250
Depression
$1,200
Weight loss
$345

Phase III: Success

Phase II: Depression
10%

85%
Phase III: Failure
15%
Phase III: Success

Phase II: Weight Loss

15%

Phase III: Failure

25%
Phase III: Success

Phase I: Success

70%

60%
In-License

75%

Phase II: Both

5%

Phase III: Success

15%
Phase III: Success
5%
Phase III: Failure

Phase II: Failure

Phase I: Failure
40%
Do not License

70%

40%

10%

5.10%

0.90%

6.75%

2.25%

Both
2.10%

Depression
0.45%

Weight
loss
0.15%

0.30%

42%
Total = 100%

Phase III: Success

85%

Phase II: Depression

10%

-$200

-$250

$1,200

Phase III: Failure

-$270

15%
-$0
Phase III: Success
75%

Phase II: Weight Loss

15%

-$150

25%
-$0
Phase III: Success

-$40

In-License

70%

5%

-$400

Phase III: Success

Phase II: Both

-$30

15%
-$500

-$250

Phase III: Success

5%
-$100
Phase III: Failure

Phase II: Failure

Phase I: Failure
40%
Do not License
-$0

-$0

70%

-$30

10%
-$0

$345

Phase III: Failure

Phase I: Success
60%

-$100

-$70

-$0

$680

$25
-$220

Both
$1280
$2,250
Depression
$380
$1,200
Weight
loss
-$325

$345

-$570

Phase III: Success

85%

Phase II: Depression

10%

-$200

-$250

$1,200

Phase III: Failure

-$2.4

15%
-$0
Phase III: Success
75%

Phase II: Weight Loss

15%

-$150

-$40

In-License

5%

-$30

Phase III: Failure

70%

-$400

Phase III: Success

Phase II: Both

15%
-$500

-$250

Phase III: Success

5%
-$100
Phase III: Failure

Phase II: Failure

Phase I: Failure
40%
Do not License
-$0

-$0

70%

-$12.0

$1.7

$345

-$5.0

25%
-$0
Phase III: Success

Phase I: Success
60%

-$100

10%

-$0

$34.7

Both
$26.90

$2,250

Depression
$1.7
$1,200
Weight
loss
-$0.5

$345

-$1.7

-$0-$29.4

Total = $14.0

Davanriks Probability
Phase

Davanrik Failure Probability

Fail Probability
Fail Probability
Per Phase
Total

I
II
III Depression
III Weight Loss
III Dual Indication
Total

40%
60% x 70%
60% x 10% x 15%
60% x 15% x 25%
60% x 5% x 10%

40.00%
42.00%
0.90%
2.25%
0.30%
85.45%

Phase III failure probability =32

3.45%

Expected Value of Milestone Payments to LAB (Million of Dollars)

Milestone
Payment
(Millions)

Probability

Expected
Milestone
Payment

Initial

$5.00

100%

$5.0

Phase I Success

2.50

60%

1.5

Phase II Depression

20.00

60% x 10%

1.2

Phase II Weight Loss

10.00

60% x 15%

0.9

60% x 5%

1.2

Phase II Dual Indication 40.00

Total

9.8
34

Expected Value of Royalty Payments to LAB

Gross CF Royalty Probability Expected
(%)
(%)
Royalty
Depression Independent Claim

5.10

$3.22

Weight Loss Independent Claim 363

6.75

1.23

Depression Dual Claim

1263

0.45

0.28

Weight Loss Dual Claim

363

0.15

0.03

Dual Claim

2368

2.10

2.49

14.55

7.25

Total

$1263

35

Capital Budgeting Techniques

Traditional Non risk based - Non-discounting techniques
Pay Back Period (PBP)
Accounting Returns on Investment (ARR)

Modern Non risk based - discounting techniques

Net Present Value (NPV)
Internal Rate of Return (IRR)
Multiple IRR
Modified Internal Rate of Return (MIRR)

Present value Index (PI)

Equivalent Annuity (EA)
Non risk based techniques assumes that all projects were assumed to be equally risky,
acceptance of any project would not alter the firms overall risk
39

Capital Budgeting Techniques

Risk based techniques

Sensitivity analysis
Scenario analysis
Certainty equivalent model
Decision tree analysis
Break even analysis
Simulation
Risk adjusted discount rate
Real options

40

Decision Analysis
Logical and systematic approach for analyzing decision
problems
Steps.,
Identify criteria for choosing among competitive alternatives
Structure decision problem, listing alternatives and uncertain events in
chronological order and representing them in a decision tree
Assess the likelihood of the various uncertain events and assign values
to the various outcomes of the decision problem
Analyze the information provided in the first three steps to determine
which alternative to undertake
Determine if the decision is sensitive to changes in probabilities or
other assumptions you have made

41

Decision Tree
Chronological sequence of options and uncertain events in a
decision tree
Maximizing expected monetary value (EMV)
EMV = probability * net cash flow
Outcome depends on external event making it uncertain
Probabilities..,
Likelihood of uncertain events
Precise numerical language for communicating judgments about the
uncertain future
Explicit in pronouncements
Are formed based on researches

42

Decision Tree
Probability in DTA is objective
Decision method folding back the tree or backwards
induction
Deals with uncertain inputs parameter values that are
subject to uncertainty known only after a decision is made
Probability tree
Visual tool that can represent key elements in a model for
decision making under uncertainty and help organize those
elements by distinguishing between decisions (controllable
variables) and random events (uncontrollable variables)
43

Payoff Tables
Cost or revenue
Is a measure of economic result
Regret = for any state and any specific action, the regret
is the monetary difference between the best possible
payoff for that state and payoff for the specific action
Expected value = weighted average outcome, where
the weights are probabilities of each state
States in Merck decision = 2 x 2 x 4 x 8 = 128
44

Decision Tree
Risk profile = distribution associated with a particular action
Useful in situations where there are multiple sources of
uncertainty and sequence of decisions to make
Expected value of perfect information (EVPI) = measures the
difference, or the gain due to perfect information
EVPI = measures the difference between certain payoff that could be realized
under a condition of certainty and the expected payoff under a condition
involving risk
EVPI = EPC EMV
EPC = expected payoff under certainty

45

Character of Decision Theory Problems

List of alternatives
Must be a set of ME and collectively exhaustive decision that are available to the decision maker

List of possible future states of nature

Set of possible future conditions, or events, beyond the control of the decision maker that will be
the primary determinants of the eventual consequences of the decision
Must be ME and collectively exhaustive

Payoffs associated with each alternative / state of nature combination

Estimated values
Profits revenues costs other measure of value
May be monthly daily yearly weekly
May be present value of future cash flows

Assessment of the degree of certainty of possible future events

Decision criterion
Maximize expected payoff
Minimize opportunity cost

46

Approaches to Decision Making Under

Complete Uncertainty
Maximin
Maximax
Minimax regret
Hurwicz
Equal likelihood

47

Deciding Between Projects with Same

Present Value
Duration can be used
Duration = tPt / Pt
t = period
Pt = cash flows received in a period

If interest rate is expected to increase (shift in yield curve

and not a twist), should prefer investment with shorter
duration, since its present value would decline by less as
result of the interest rate increase and vice versa

48

Duration - Example
Discount Rate
Time
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15

8%
4
$160
200
350
395
432
440
442
444
446
448
450
451
451
452
(2,000)

CF
5
280
280
280
280
280
280
280
280
280
280
280
280
280
280
280

8
($350)
(60)
60
350
700
1,200
2,250

NPV

4
148.15
171.47
277.84
290.34
294.01
277.27
257.90
239.88
223.11
207.51
193.00
179.10
165.83
153.89
-630.48
2448.82
448.82

PVCF
5
259.26
240.05
222.27
205.81
190.56
176.45
163.38
151.28
140.07
129.69
120.09
111.19
102.96
95.33
88.27
2396.65

tPVCF
8
4
5
8
-324.07
148
259
-350
-51.44
343
480
-120
47.63
834
667
180
257.26
1161
823
1400
476.41
1470
953
3500
756.20
1664
1059
7200
1312.85
1805
1144
15750
1919
1210
2008
1261
2075
1297
2123
1321
2149
1334
2156
1338
2154
1335
-9457
1324
2474.84 12552.27 15804.64 27560.00
Duration
5.13
6.59
11.14
396.65
474.84

49