1) Build a decision tree that shows the cash flows and probabilities at all stages of the FDA approval

process.

As we can see in the exhibits, Merck and Co has a high return on capital from 1997 to 1999. The company has
developped new compounds in the chemical area through internal research, it has also worked with external
biotechnology company to complement the internal research and developpement. The company has a lot of
patents and therefore they have exclusivity on the sales of their medications. Our case consider a external
biotechnology company, where we continue or abandon the project if the NPV is positiv or negativ. The
licensing of Davanrik could result either in a depression medication or weight medication, or even both
medication together.

Following the multiple decisions, we will have a decision tree with the probability of each event and the Cash
Flows discounted. We must consider all possible outcome at each stage of the FDA approval. As we can see if
figure 1, the outcome can have large variation.

2) Analyze whether Merck should license the drug (using your decision tree). What royalties, as a fraction of
generated cash flows, should the company propose to pay to LAB? ( and question 3 too )

According to the probability, the expected net present value of the project is 13.98 USD. This amount represent a
positiv NPV, which lead us to the decision to undertake the project, as the NPV seems good. We must take it
with consideration since the project has large variation and it’s risky.

Merck should not bid more than this 13.98. In fact, they should impose even a lower amount to generate a profit,
and not only staying at 0 NPV. We must not forget that there is always the stop option, they can stop the
approval process to avoid more cost, knowing that they will have a negativ NPV in the future. The figure 2
shows us all the probability with their expected gain or loss.

To have a positiv NPV, we must consider again an amout as near as possible to 13.98. 4.18 millions total of
royalties MAXIMUM are possible with a 3% of royalties, as a fraction of the cash flow generated, i.e. the
revenues. We know that we have the expected value of Payments to LAB at each stage, plus the total royalties
each year. The expected payments to LAB amounts a total of 9.8 millions, as we can see in figure 3. The total
amount of royalites for this part equals 4'269'375, with detailed calculations in the figure 4. LAB, at the end and
for this period of time, will receive an expected amount of 14'069'375 of cash by licensing agreement. The bid
from Merck is 13.98, and this is also an amount they will receive. In conclusion, this would be a good deal for
LAB to offer the licence. However, from the point of view of Merck, they have to accept too.

A last view on the figure 5 gives us the expected value of offering the licence, with a good perspective in each
case.case. It’s profitable to LAB to give such an offer to Merck to license the product Davanrik, as the expected
sorrypayments to LAB plus the expected royalties give attractive positiv net value.
 Appendices

Bid for the

licence
Enter phase Do nothing
about licence
1 0 Gain or Loss

30 mios
USD
of COST
Enter of Phase
Failing phase I
II, successing
phase I LOSS of 30 mios
USD
Additional 40
mios USD of
COST

Medication Medication Failing phase II

only on Medication
only on cumulated 70
weight on
depression mios USD of
depression
200 millions 150 mios COST
AND weight
USD of USD of COST
500 mios
COST fail :
Enter phase III USD of COST
cumulated
Enter phase III / / Approve for 220 mios
Fail : weight Fail :
Approve for cumulated USD of COST Success Success Both cumulated
depression 270 mios 100 mios depression weight only success 570 mios of
250 mios USD of USD of USD of COST only 100 mios COST
COST
cost
250 mios USD of COST 400 mios
PV USD of USD of
PV COST PV 345 COST
345
1.2 Billion Millions Million PV
PV
s
1.2 Billion 2.25 Billion

Figure 1 Decision tree of licencing

Probabilities  :
First branch  : Success phase I p=0.6 – do nothing  p=0.4
Second branch  : Depression p=0.1 – Weight p=0.15 – Both p=0.05 – Fail p=0.7
Third branch of Depression  : Success p=0.85 – Fail 0.15
Third branch of Weight  : Success p=0.75 – Fail 0.25
Third branch of BOTH  : Success p=0.15 ending Depression – success p=0.05 ending weight – success both p=0.7
Fail p=0.1

Event of Success Depression : Profit 680 USD / Probability 5.1 % (0.6*0.1*0.85) – Expected
Profit 34.68 USD

Fail of Depresion : Loss -270 USD / Probability 0.9% - Expected Loss -2.43 USD

Sucess Weight : Profit 25 USD / Probability 6.75% - Expected Profit 1.69 USD

Fail of Weight : Loss -220 / Probability 2.25 % - Expected Loss -4.95 USD
Phase I : 5'000'000 of fees with 100 % probability. We expected to pay 5'000'000.

Phase II Success : 2'500'000 of fees with 60% probability, we expect to pay 1'500'000.

Phase III Depression : 20'000'000 of fees with 6% probability ( 0.6*0.1 ), we expect to pay
1'200'000.

Phase III Weight : 10'000'000 of fees with 9% probability ( 0.6*0.15), we expect to pay
900'000.

Phase III Both : 40'000'000 of fees with 3% probability ( 0.6*0.05 ), we expect to pay
1'200'000.

Figure 3 Fees to pay to LAB

Depression Success : Generated CF ( Revenues ) 1.2 Billion – 3% Royalty – Probability 5.1%

Weight Success : Generated CF ( Revenues ) 345 Millions – 3% Royalty – Probability 6.75 %

Both with both success : Generated CF ( Revenues ) 2.25 Billions – 3% Royalty – Probability 2.1
%

Both but Depression success : Generated CF ( Revenues ) 1.2 Billion – 3% Royalty – Probability
0.45 %

Both but weight loss : Generated CF ( Revenues ) 345 Millions – 3% Royalty – Probability 0.15
%

In calculation, we have : 1.2*0.03*0.051 + 0.345*0.03*0.0675 + 2.25*0.03*0.021 +

1.2*0.03*0.045 + 0.345*0.03*0.015 = 4'269’375

Figure 4 Expected royalties paid at 3%

Offering
the licence
Do nothing
about licence
Enter 0 Gain or Loss

phase 1
5 millions

Enter of Phase Failing phase I

II, successing 0
phase I
2.5 millions

Medicatio Medication
n only on only on Medication Failing phase II
depressio weight on 0
n depression
10 millions AND weight
20
millions Enter phase 40 millions
Fail
III / Approve
Enter phase III / for weight 0
Success
Approve for Fail Success Both Fail :
10.35 weight only
depression 0 depression cumulated 0
millions only 10.35 success
36 millions
36 Millions 67.5
Millions Millions
Figure 5 Decesion tree from the point of view of LAB