Risk Based Investment Decisions

Case: Merck & Company:

Evaluating a Drug Licensing
Opportunity
COMPOUND SUCCESS RATES BY STAGES Compound Success
Rates by Stage

Discovery 5,000-10,000
screened
(2-10 Years)

Preclinical Testing 250

enter preclinical testing
Laboratory and animal testing

Phase I 5
enter clinical testing
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

Approved by the FDA

0 2 4 6 8 10 12 14 16
13
Years
 Davanrik’s Potential
Cash Flows
Phase I Phase II Phase III
(clinical testing)
Tested on 20-80 healthy 100-300 1000-5000 of
volunteers of patient volunteers patients
Tested for Safety Effectiveness Safety and efficacy
Potential side effect 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 / $5 million $2.5 million Depression: 20 mn
Milestone fee Weight loss: $10 mn
to LAB Both: $40 mn

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 Davanrik’s Potential
Cash Flows
Phase I Phase II Phase III
(clinical testing)
Chance of 60% Depression: 10% Depression: 85%
success Weight loss: 15% Weight loss: 75%
Both: 5% Both: 70%

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

15
 Davanrik’s Potential
Cash Flows
Depression only Weight loss only Both
Cost to launch $250 million $100 million $400 million
Commercialization $1.2 billion $345 million $2.25 billion
present value

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
• 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
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 Decision Alternatives

Decision Alternatives

Phase I Phase II Phase III

(Safety) (Efficacy) (Long Term Use)
Success Depression Success

Failure Weight loss Failure

Both

Failure

22
 Phase III: Success

Phase II: Depression

Phase III: Failure

Phase III: Success

Phase II: Weight Loss

Phase III: Failure

Phase I: Success Phase III: Success

Both

In-License Phase III: Success Depression

Phase II: Both

Phase III: Success Weight loss

Phase III: Failure

Phase II: Failure

Phase I: Failure

Do not License
 Phase III: Success
85%
Phase II: Depression

10%
Phase III: Failure

15%
Phase III: Success

Phase II: Weight Loss 75%

15% Phase III: Failure

25%
Phase I: Success Phase III: Success
Both
60% 70%

In-License Phase III: Success Depression

Phase II: Both
15%
5%
Phase III: Success Weight loss

5%
Phase III: Failure
Phase II: Failure 10%

70%
Phase I: Failure

40%

Do not License
 Phase III: Success
85% -$250
Phase II: Depression

10%
-$200 Phase III: Failure

15% -$0
Phase III: Success

Phase II: Weight Loss 75% -$100

15% -$150 Phase III: Failure

25% -$0
Phase I: Success Phase III: Success
Both
60% -$40 70% -$400

In-License Phase III: Success Depression

Phase II: Both
15% -$250
5%
-$30 -$500 Phase III: Success Weight loss

5% -$100
Phase III: Failure
Phase II: Failure 10% -$0

70% -$0
Phase I: Failure

40% -$0

Do not License

-$0
 Phase III: Success
85% -$250 $1,200
Phase II: Depression

10%
-$200 Phase III: Failure

15% -$0
Phase III: Success

Phase II: Weight Loss 75% -$100 $345

15% -$150 Phase III: Failure

25% -$0
Phase I: Success Phase III: Success
Both
60% -$40 70% -$400 $2,250

In-License Phase III: Success Depression

Phase II: Both
15% -$250 $1,200
5%
-$30 -$500 Phase III: Success Weight loss

5% -$100 $345
Phase III: Failure
Phase II: Failure 10% -$0

70% -$0
Phase I: Failure

40% -$0

Do not License

-$0
 Phase III: Success
85% 5.10%
Phase II: Depression

10%
Phase III: Failure
0.90%
15%
Phase III: Success

75%
6.75%
Phase II: Weight Loss

15% Phase III: Failure

2.25%
25%
Phase I: Success Phase III: Success
2.10%
Both
60% 70%

Phase III: Success

In-License
Phase II: Both 0.45%
Depression
15%
5%
Phase III: Success
0.15%
Weight loss

5%
Phase III: Failure
Phase II: Failure
0.30%
10%

70% 42%
Phase I: Failure
40%
40%

Total = 100%
Do not License
 Phase III: Success
85% -$250 $1,200 $680
Phase II: Depression

10%
-$200 Phase III: Failure
-$270
15% -$0
Phase III: Success

75% -$100 $345

$25
Phase II: Weight Loss

15% -$150 Phase III: Failure

-$220
25% -$0
Phase I: Success Phase III: Success
$1280
Both
60% -$40 70% -$400 $2,250

Phase III: Success

In-License
Phase II: Both $380
Depression
15% -$250 $1,200
5%
-$30 -$500 Phase III: Success
-$325
Weight loss

5% -$100 $345
Phase III: Failure
Phase II: Failure
-$570
10% -$0

70% -$0 -$70

Phase I: Failure
-$30
40% -$0

Do not License

-$0
 Phase III: Success
85% -$250 $1,200 $34.7
Phase II: Depression

10%
-$200 Phase III: Failure
-$2.4
15% -$0
Phase III: Success

75% -$100 $345

$1.7
Phase II: Weight Loss

15% -$150 Phase III: Failure

-$5.0
25% -$0
Phase I: Success Phase III: Success
$26.90
Both
60% -$40 70% -$400 $2,250

Phase III: Success

In-License
Phase II: Both $1.7
Depression
15% -$250 $1,200
5%
-$30 -$500 Phase III: Success
-$0.5
Weight loss

5% -$100 $345
Phase III: Failure
Phase II: Failure
-$1.7
10% -$0

70% -$0-$29.4
Phase I: Failure
-$12.0
40% -$0

Total = $14.0
Do not License

-$0
 Davanrik’s Probability
Davanrik Failure Probability
Phase Fail Probability – Fail Probability
Per Phase Total
I 40% 40.00%
II 60% x 70% 42.00%
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%

Phase III failure probability = 3.45%

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Expected Value of Milestone Payments to LAB (Million of Dollars)
Milestone Probability Expected
Payment Milestone
(Millions) 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
Phase II Dual Indication 40.00 60% x 5% 1.2
Total 9.8

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 Expected Value of Royalty Payments to LAB
Gross CF Royalty Probability Expected
(%) (%) Royalty
Depression – Independent Claim $1263 5 5.10 $3.22
Weight Loss – Independent Claim 363 5 6.75 1.23
Depression – Dual Claim 1263 5 0.45 0.28
Weight Loss – Dual Claim 363 5 0.15 0.03
Dual Claim 2368 5 2.10 2.49
Total 14.55 7.25

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 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 firm’s overall risk
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 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

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