Merck & Company Case
1. How has Merck done as a pharmaceutical business? Is it a profitable business model?
What are the risks and rewards associated with this model?
Merck was a global research-driven pharmaceutical company. Over the last three years, Merck
had achieved close to 20% profit from sales of patent drugs. However, the high profit margin
was based on the patent protection. Once the patents expire, the sales of these drugs would
decline substantially as generic substitutes became available. Exhibit 1 shows that Merck was
profitable. Exhibit 2 shows that Merck’s current ratios over the past two years were greater than
1, which indicated that it has high liquidity. Its healthy financial position indicated that it was
able to fund new drugs’ development internally and externally.
Financial Ratio Analysis
1999 1998 1997
Current Ratio 1.29 1.69
Equity Multiplier 2.69 2.49
Profit Margin 18.01% 19.51% 19.52%
ROA 16.53% 16.48%
ROE 44.48% 41.00%
EPS 2.51 2.21 1.92
Dividend Payout Ratio 44.64% 44.83% 45.40%
Retention Ratio 55.36% 55.17% 54.60%
Internal Growth Rate 10.07% 10.00%
Sustainable Growth Rate 24.63% 22.62%
2. What are the potential outcomes for Davanrik? Build a decision tree that shows the
cash flows and probabilities at all stages of the FDA approval process.
We built a decision tree that shows the cash flows and probabilities at all stages of the FDA
approval process (Appendix 1). The total expected monetary value for licensing Davanrik is
$13.98 million.
3. Should Merck bid to license Davanrik? How much should they pay?
The project has a healthy expected value of $13.98 million. In case the project succeeds, Merck
will recover its investments and gain huge profit. Moreover, many of Merck’s patents will expire
soon and lose its competitive advantage. Merck needs to invest in new project as soon as possible
to capture the market share. Thus, we think Merck should bid to license Danvanrik.
However, we need to take into consideration that the failure rate is very high (85.45%). And the
seven-year approval process is a large investment for Merck. Based on the decision tree, the
probability of the Davanrik to be success is very low (14.55%).
Effective for Depression Weight Both
loss
Probability of success 5.55% 6.9% 2.10%
NPV 36.39M 1.2M 26.9M
From Exhibit 1, we calculated the retained earnings as a percentage of income before tax. The
average percentage for 1998 and 1999 is 36.72%. Merck should maintain the return for this deal.
Thus the licensing fee Merck can bid for is $5.13 million (=36.72% * 13.98 million).
Year Ended December 31,
1999 1998 1997
Income Before Taxes 8,619.5 8,133.1 6,462.3
Retained Earnings Balance, December 31 23,447.9 20,186.7 17,291.5
Retained Earnings/Income Before Taxes 37.84% 35.60%
Average 36.72%
Even though Davanrik has potential profits, Merck should not bid to the license.
4. What is the expected value of the licensing arrangement to LAB? Assume a 5% royalty
fee on any cash flows that Merck receives from Davanrik after a successful launch.
Licensing Royalty Total
PMT fee value
Expected value of only effective on depression 1.4025M 3.06M 4.46M
Expected value of only effective on weight loss 1.18125M 1.16M 2.34M
Expected value of effective on both 0.9975M 2.36M 3.36M
Expected value of effective on depression at last 0.214M 0.27M 0.484M
stage
Expected value of effective on weight loss at last 0.07M 0.026M 0.096M
stage
Expected Value of Milestone Payments to LAB
($ in millions)
Expected
Milestone
Probability Milestone
Payment
Payment
Initial $5.0 100% $5.0
Phase I Success $2.5 60% $1.5
Phase II Depression $20.0 60% * 10% $1.2
Phase II Weight Loss $10.0 60% * 15% $0.9
Phase II Both Success $40.0 60% * 5% $1.2
Total $9.8
Expected Value of Royalty Payment to LAB
($ in millions)
Expected
Gross Cash
Probability Royalty Royalty
Flow
Payment
Depression Only $1,200 5.10% 5% $3.06
Weight Loss Only $345 6.75% 5% $1.16
Depression Only at Phase III $1,200 0.45% 5% $0.27
Weight Loss Dual at Phase III $345 0.15% 5% $0.03
Both $2,250 2.10% 5% $2.36
Total $6.88
When Davanrisk was launched successfully, LAB is expected to receive $16.68 million from
licensing and royalty fee.
5. How would your analysis change if the costs of launching Davanrik for weight loss were
$225 million instead of $100 million?
If the cost of launching Davanrik for weight loss were $225, the squared area in decision tree
should be changed to -$225 instead of -$100. Then, its total expected cash flow changes to -$100
and its expected PV is $-6.75 million (6.75% * -$100 million). Then, its total expected value is
decreased from about $14 million to $5.6 million. In this case, we do not change our analysis to
do not bid to the license because the cash flow is decreased given the same low possibility of
success.
From the tree (Appendix 2), we see that when the launching costs were $225, launching Davanrik
for weight loss would lead to a loss. However, the total EMV is still positive ($5.36 million).
Hence, Merck should still launch the drug. But different decisions will be made during the
process.
When the costs were $225 million, if Merck finds out that Davanrik can cure only weight loss
after Phase II, it should not proceed to Phase III. Since the loss incurred ($70 million) will be less
than the loss ($100 million) if the product is launched. While the costs were $100 million, it
would be -$70 million vs. $25 million.
