Risk Based Investment

Decision
Case: Merck & Company:
Evaluating a Drug Licensing
Opportunity
1

Broad
range
human and
animal
health
products

Merc
k

Directly
Through joint ventures
Providing pharmaceutical benefit
management services (PBM)
through Merck-Medco Managed
care

Lab

Davanrik

Initial fee
Responsible for the approval of Davanrik, its
manufacture, and its marketing
Royalty on all sales

Merc
k

Responsible for the approval of Davanrik, its

manufacture, and its marketing
Senior researchers: evaluated scientific aspects of
the compound
Marketers: evaluate market size, potential
competition, and requirements to successfully
launch the drug
Manufacturing manager: determine the capital
required to produce the drug
Financial experts: financial 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

0
Years

10

12

14

16

Approved by the FDA

6

Phase I
Tested on

20-80
healthy
volunteers

Phase II
(clinical testing)

Phase III

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

$5 million

$2.5 million

Depression: 20
mn
7
Weight loss: $10

Probability of Success
Phase I

Chance of
success

Phase II
(clinical testing)

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

60%

Phase III
Depression: 85%
Weight loss: 75%
Both: 70%
Depression: 15%
Weight loss: 5%
Both: 10%

Cash Flows
Cost to launch
Commercialization
present value

Depression only

Weight loss only

Both

$250 million

$100 million

$400 million

$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
8
its patent by then (and thus a terminal value of zero was used in the calculations)

Possible
Outcome

Probability

10

Cash Outflow

Commercial
Value

$1200
mn
$345 mn
$2250
mn
$1200
mn
$345 mn

Failure
Probability
0.90%

2.25%

40%

42%

0.30%
Total: 85.45%

Success
Probability

6%
60%
9%

3%

5.10%

6.75%
2.10%
0.45%
0.15%

Total: 92.55%

Total Possible
Probability
5.10%
0.90%
6.75%
2.25%
2.10%
0.45%
0.15%
40%

42%

0.30%
Total: 10%

Cash Flow
Outcome
$680 mn
-$270
mn
$25 mn
-$220
mn
$1280
mn
$380 mn
-325 mn
-$30 mn

-$70 mn

-570 mn

Expected Cash
Flow
5.10%*$680 mn = $34.7
mn
0.90%*-$270 mn = -$2.4
mn

6.75%*$25 mn = $1.7 mn

2.25%*-$220 mn = -$5
mn
2.10%*$1280 mn =
$26.90 mn

0.45%*$380 mn = $1.70
mn
0.15%*-$325 mn = -$0.5
mn
40%*-$30 mn = -$12
mn
42%*-$70 mn = $29.4 mn

Expected value = weighted average

outcome, where the weights are

0.30%*-370 mn = -$ 1.7
mn

Total: $14 mn

Expected
Milestone
Payment

6%* $20 mn =
$1.2 mn
60% * $2.5 mn
= $1.5 mn

100% * $5mn
= $5mn

9% * $10 mn =
$0.9 mn

3% * $40 mn =
$1.2 mn

Total: $9.8 mn

Expected Royalty
Payment
5.10% * $1263 mn *5% =
$3.22 mn

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

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

2.10% * $1263 * 5% =
$0.28 mn
0.45% * $363 mn * 5% =
$0.03 mn

Total: $7.25 mn

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