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Executive SummaryIn 2000, Merck & Co., Inc., a global research-driven pharmaceutical company, was facing a threat that patentsof their most popular drugs would expire in two years. Following by the patents expiration,

companys sales and profits would decline dramatically since generic substitutes would take place. Theonly way to recover the loss caused by patents expiration was to develop new drugs and refresh the

companys portfolio.

LAB Pharmaceuticals, who specializes in developing compounds for treatment of neurological disorders,offered Merck to license a new developing drug, Davanrik, which had functions to treat depression, obesity or

both. At the time of the offer, Davanrik was in pre-clinical development, which would need to pass the three-phase clinical tests approved by the FDA. Testing would last seven years, which would appear to be highfailure and costly. Under the licensing agreement, Merck would be responsible for the approval of Davanrikfrom the FDA, its manufacturing, and its marketing. As return, Merck would pay LAB an initial fee, a loyaltyon all sales, and make additional payments as Davanrik completed each stage of the approval process.As Mercks financial evaluation team, we analyzed this offer through decision tree analysis, and estimatedthe expected value from each possible outcome and the expected payments to the LAB. We concluded theexpected value of licensing Davanrik is around $13.69 million, which included the expected payments to theLAB of $16.68 million.Our recommendation is that Merck should bid on licensing Davanrik no more than $13.69 million. First, thecompany is facing a serious situation that most of their patents are going to expire soon, and the companys

value and profits are declining, so it is necessary to invest in new drug developments. Second, the FDAapproval tests are seven years long with a high failure rate. If Merck fails tests in the middle way, the companywould not only loss the opportunity to produce and market the drug, but also face huge loss caused by failure,so the bid can not be set too high. Third, Merck had rich experience and technology source with drugdevelopment process, so the company should have financial and technical abilities to support Davanriks

approval process with the FDA. We estimated the projects expected value by sum up expected valuesfrom positive outcomes and negative outcomes, and concluded that it is worth to bid but with caution as the

project will be subject to high risk. Our analysis details are as following.The ProblemMerckMerck was a successful research-driven pharmaceutical company, which discovered, developed, manufacturedand marketed a broad range of human and animal health products. Over the last three years, Merck hadachieved close to 20% profit from sales of executive patent drugs. However, most of the revenue generators,

patented drugs, were going to become generic drugs in two years. There was a sign that goodwill andintangibles were declining from 26% to 21% for 1998 to 1999, and we anticipated a deeper drop when more

patents get expired in 2002. If there would be no substitutes which could take place to generate revenue afterpatents get expired in two years, the companys profit and EPS would decrease, which would make it lessattractive to investors, so the companys value would decline.The only way to counter the loss of sales form drugs going off patent was to develop new drugs and constantlyrefresh the companys portfolio. From the analysis of companys common - size financial statements, itappeared that the firm was financially healthy. Moreover, Merck was able to fund new drugs development

through both internal and external funding.From the common size balance sheet: All three years current ratios were greater than 1, which indicatedthat the company has high liquidity. The debt to equity ratios were great than 1, which seemed the companyhad a heavier debt than equity, but it was not the truth. Current liabilities, deferred income taxes and non-

current liabilities, and minority interests had a larger percentage than the long-term debt in total liabilities.Additionally, there was high percentage of treasury stock in stockholders equity, which reduced the totalequity.From the common size income statement: Over the last three year, the company had a high gross margin from46% to 50%, which indicated company efficiently utilized assets to earn substantial profit. Moreover, profitmargin, ROA, ROE and EPS all indicated the company was profitable, which should be attractive to bothcreditors and investors. Since the retention ratio was pretty high, the company was able to reach a higher return

by reinvesting the retained earnings.

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Overall, Mercks healthy financial position indicated that it was able to fund new drugs development

internally and externally. It could invest by utilizing funding from retained earning, reselling of treasurystocks, issuing stocks to investors, or issuing bonds to creditors.Table 1 - Common Size Balance SheetYear Ended December 31, Year Ended December 31,1999 1998 1999 1998

AssetsCurrent AssetsCash and cash equivalents 2,021.9 2,606.2 5.67% 8.18%Short-term investments 1,180.5 749.5 3.31% 2.35%Accounts receivable 4,089.0 3,374.1 11.47% 10.59%Inventories 2,846.9 2,623.9 7.99% 8.24%Prepaid expenses and taxes 1,120.9 874.8 3.15% 2.75%Total current assets 11,259.2 10,228.5 31.60% 32.11%Investments 4,761.5 3,607.7 13.36% 11.33%Property, Plant and Equipment (at cost)Land & Buildings 4,725.0 3,892.8 13.26% 12.22%Machinery, equipment and office furnishings 7,385.7 6,211.7 20.73% 19.50%Construction in progress 2,236.3 1,782.1 6.28% 5.59%

14,347.0 11,886.6 40.26% 37.32%Less allowance for depreciation 4,670.3 4,042.8 13.11% 12.69%9,676.7 7,843.8 27.16% 24.62%Goodwill and Other Intangibles 7,584.2 8,287.2 21.28% 26.02%Other Assets 2,353.3 1,886.2 6.60% 5.92%35,634.9 31,853.4 100.00% 100.00%Liabilities and Stockholders EquityCurrent LiabilitiesAccounts payable and accrued liabilities 4,158.7 3,682.1 11.67% 11.56%Loans payable and current portion of long-term debt 2,859.0 624.2 8.02% 1.96%Income tax payable 1,064.1 1,125.1 2.99% 3.53%Dividends payable 677.0 637.4 1.90% 2.00%Total current liabilities 8,758.8 6,068.8 24.58% 19.05%Long-Term Debt 3,143.9 3,220.8 8.82% 10.11%Deferred Income Taxes and Noncurrent Liabilities 7,030.1 6,057.0 19.73% 19.02%Minority Interests 3,460.5 3,705.0 9.71% 11.63%Stockholders EquityCommon Stock 29.7 29.7 0.08% 0.09%Other Paid-in capital 5,920.5 5,614.5 16.61% 17.63%Retained earnings 23,447.9 20,186.7 65.80% 63.37%Accumulated Other Comprehensive Income (loss) 8.1 (21.3) 0.02% -0.07%29,406.2 25,809.6 82.52% 81.03%Less treasury stock, at cost 16,164.6 13,007.8 45.36% 40.84%Total stockholders equity 13,241.6 12,801.8 37.16% 40.19%35,634.9 31,853.4 100.00% 100.00%

Table 2 - Common Size Statement of Income & Retained EarningsYear Ended December 31, Year Ended December 31,1999 1998 1997 1999 1998 1997Sales 32,714.0 26,898.2 23,636.9 100.00% 100.00% 100.00%Costs, Expenses, and OtherMaterials and production 17,534.2 13,925.4 11,790.3 53.60% 51.77% 49.88%Gross margin 15,179.8 12,972.8 11,846.6 46.40% 48.23% 50.12%Marketing and administrative 5,199.9 4,511.4 4,299.2 15.90% 16.77% 18.19%Research and development 2,068.3 1,821.1 1,683.7 6.32% 6.77% 7.12%

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Acquired research 51.1 1,039.5 0 0.16% 3.86% 0.00%Equity income from affiliates (762.0) (884.3) (727.9) -2.33% -3.29% -3.08%Gains on sales of businesses 0 (2,147.7) (213.4) 0.00% -7.98% -0.90%Other (income) expense, net 3.0 499.7 342.7 0.01% 1.86% 1.45%24,094.5 18,765.1 17,174.6 73.65% 69.76% 72.66%Income Before Taxes 8,619.5 8,133.1 6,462.3 26.35% 30.24% 27.34%

Taxes on Income 2,729.0 2,884.9 1,848.2 8.34% 10.73% 7.82%Net Income 5,890.5 5,248.2 4,614.1 18.01% 19.51% 19.52%Basic Earnings per Common Share 2.51 2.21 1.92 0.01% 0.01% 0.01%Earnings per Common Share Assuming Dilution 2.45 2.15 1.87 0.01% 0.01% 0.01%Retained Earnings Balance, January 1 20,186.7 17,291.5 14,772.2 61.71% 64.28% 62.50%

Net Income 5,890.5 5,248.2 4,614.1 18.01% 19.51% 19.52%Common Stock Dividends Declared (2,629.3) (2,353.0) (2,094.8) -8.04% -8.75% -8.86%Retained Earnings Balance, December 31 23,447.9 20,186.7 17,291.5 71.68% 75.05% 73.15%Table 3 - Financial Ratio Analysis1999 1998 1997Current Ratio 1.29 1.69Total Debt Ratio .63 .60Debt/Equity Ratio 1.69 1.49

Equity Multiplier 2.69 2.49Profit Margin 18.01% 19.51% 19.52%ROA 16.53% 16.48%ROE 44.48% 41.00%EPS 2.51 2.21 1.92Retention Ratio 55.36% 55.17% 54.60%Dividend Payout Ratio 44.64% 44.83% 45.40%Internal Growth Rate 10.07% 10.00%Sustainable Growth Rate 32.68% 29.22%LAB PharmaceuticalsLAB, a specialized pharmaceutical company, was offering Merck to license his new developing drug, whichwas ready to enter the three-phase clinical testing. LAB already had a few drugs under the three testing phases.Some were denied by the FDA after all three tests, and others were still under testing phases, so none of themsuccessfully completed the FDA approval. LABs stock price dropped 30% due to failure of testingapproval. Therefore, LAB could not raise enough funds to support Davanrik to pass all three phases and getapproval from the FDA, and they were looking for a larger company, who had financial ability to successfullycomplete clinical tests, and launch the drug into market. In return, LAB would receive an initial payment,additional payments as Davanrik completes each clinical testing phase, and a royalty based on Danvanriks

sales.Drug DevelopmentOn average, it takes 13 years for an experimental drug to travel from lab to market. All new drugs need proofthat they are effective, as well as safe, before they can be launched into market. It is the FDAsresponsibility to assure the safety and efficacy of all drugs. The average rate for a new drug to pass all tests andto get approval from the FDA is one out of 50,000 or lower.Table 4 - Compound Success Rates by Stage

Discovery Preclinical Testing Phase I Phase II Phase III FDA Post-marketing TestingYears 2 to 10 4 2 2 3 2Test Population Laboratory and animal testing 20-80 healthy volunteers 100-300 patient volunteers 1000-5000

patient volunteersPurpose Assess safety and biological activity Determine safety and dosage Look for efficacy and side effectsMonitor adverse reactions to long-term use Additional post-marketing testingSuccess Rate 5000-10000 screened 250 enter preclinical testing 5 Enter clinical testing 1 approvedOnce the drug is approved by FDA, it will commercialize and be protected by patent for another ten years.Even though it is very time consuming and costly to successfully develop and launch a new drug into the

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market, the revenue generated by a patented drug is significant. Pharmaceutical companies will have excusiverights to produce and sell the drug with low costs. After the patent expires, the drug becomes generic, whichcan be legally produced by generic drug manufacturers. The expiration of a patent removes the monopoly ofthe patent holder on drug sales licensing, which will have huge impact in the patent holders sales.Pharmaceutical companies revenue and profit will decline, which causes stock price to drop.Merck had an opportunity to bid on licensing Davanrik, which might generate revenue if the drug successfully

gets approval from the FDA. It is a long-term investment with high uncertainty and high failure risk. It is also ahigh competitive industry that a company will land itself in a passive position once it losses its most patentrights, which was exactly the situation Merck had been facing to. Should Merck bid to license to Davanrik?What is the maximum bid they would be willing to pay?To evaluate this investment, Merck must look at outcomes from each phase, and their possibilities of successand failure. The bidding strategy should be based on the expected value of all possible outcomes. Also keep inmind that the FDA approval has a relative low passing rate 0.02% or lower, which means there are highchances that the tests will fail at any phase with a substantial loss.MethodologyThe bidding decision should be based on the evaluation of expected value from Davanriks potentialtesting outcomes.1. We would need to be familiar with the FDA phases of Davanriks development, and the possibilities of

passing or failing at each phase. We could utilize decision tree analysis to estimate success and failure

possibilities for each outcome.2. We have to track on costs of development from each stage including payments to LAB, costs in testing

phases, costs to launch, and loyalty to LAB. And then we could calculate the total cash outflow and inflow foreach outcome.3. We would calculate NPV for each outcome by subtracting cash outflow from inflow, and then computeexpected value by multiplying NPV to each outcomes success or failure possibility.4. We would estimate the expected payments to the LAB including the initial fee, milestone payments androyalty.5. The maximum bid should be based on sum of the expected value of all possible outcomes.Data Requirements1. To estimate the success or failure rate of each potential outcome, we would need possibilities of success andfailure of depression, weight loss and dual for each testing phase.2. To estimate cash outflow and inflow for each potential outcome, we would need all payments to LAB by

phase, costs incurred in each phase, costs to launch into market, and loyalty paid to LAB.AssumptionsThe following assumptions were made in order to properly evaluate this investment.1. All cash flows given in the case were discounted to prevent value.2. Possibilities of all outcomes in any one testing phase add up to 100%.3. The overall possibilities of final potential outcomes add up to 100%.4. Royalty will be paid to LAB at a rate of 5% of the commercialized PV.5. Initial payment, milestone payments and royalty to LAB are also subject to the same risk as the test successand failure rates at each phase.6. All launches are successful.7. Ignore tax implication for cash flow.Analysis

Davanrik Expected ValueFirst, we created a decision tree to analyze success or failure possibilities for potential outcomes for each

phase. Possibilities of success and failure, and cash flows in each stage were listed below. We conclude thatthere were five successful outcomes: depression only, weight-loss only, dual, depression from dual trial andweight-loss from dual trial. Accordingly there were five failures: failure at phase I, failure at phase II, failure at

phase III at depression test, failure at phase III at weight-loss test and failure at phase III at dual test. In total,there were ten possible outcomes with different success and failure rates.Table 5 - DECISION TREEPhase III Launch Loyalty PV NPV

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Phase IISuccess - 85% -250 -3.06 1200 676.94Depression - 10%-200 Failure - 15%0Success - 75% -100 -1.16 345 23.84

Weight Loss - 15%-150 Failure - 25%Phase I 0Success - 60% Depression - 15% -250 -0.27 1200 379.73-40 Dual - 5%-500Weight Loss - 5% -100 -0.03 345 -325.03Dual - 70% -400 -2.36 2250 1277.64Failure - 10%0License Failure - 70%-30 0Failure - 40%

0No License0Second, we listed cash outflows and possibilities of success or failure in phase I, II, III based on testingobjectives. Then we estimated possibilities for ten potential outcomes concluded from the decision tree bymultiplying possibility of success or failure at each phase. We assume that 5% royalty based oncommercialization PV to the LAB would have the same rates as the five successful outcomes concluded fromthe decision tree. We summed up cash outflows for each outcome. After that, we compute net present valueusing:NPV = cash inflow cash outflow.Third, we estimated the expected value for ten individual outcomes:EV = NPV * possibility of success/failureLast, the expected value of licensing equals to the sum of expected values of all ten outcomes. We estimatedthat sum expected value was $13.69 million, which should be the maximum bid for this investment.Table 6 - Cash Flow and EV CalculationStage Function Cash Outflow Cash Inflow Possibility of Success / Failure NPV Expected ValueI Success (30) 60%Failure (30) 40%II Depression - success (40) 10%Weight Loss (40)15%Dual (40) 5%Failure (40) 70%III Depression (200) 85%Depression - failure (200) 15%

Weight Loss (150) 75%Weight Loss - failure (150) 25%Dual - Depression (500) 15%Dual - Weight Loss (500) 5%Dual - Dual (500) 70%Failure (500) 10%Launch Depression (250) 100%Weight Loss (100) 100%Dual (400) 100%

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Loyalties Depression (3.06) 5.10%Dual - depression (0.27)0.45%Weight Loss (1.16) 6.75%Dual - Weight Loss (0.03) 0.15%Dual (2.36) 2.10%

Successful Depression (523.06) 1,200 5.100% 676.94 34.52Outcomes Dual - depression (820.27) 1,200 0.450% 379.73 1.71Weight Loss (321.16) 345 6.750% 23.84 1.61Dual - Weight Loss (670.03) 345 0.150% (325.03) (0.49)Dual (972.36) 2,250 2.100% 1,277.64 26.83Failed Failure at Phase I (30.00) - 40.00% (30.00) (12.00)Outcomes Failure at Phase II (70.00) - 42.00% (70.00) (29.40)Failure at Phase III - Depression (270.00) - 0.90% (270.00) (2.43)Failure at Phase III - Weight Loss (220.00) - 2.25% (220.00) (4.95)Failure at Phase III - Dual (570.00) - 0.30% (570.00) (1.71)Total 100% 13.69Expected Payments to LABPayments to LAB consist of initial payment, milestone payments with successful test result, and 5% royalty

based on commercialization present value. Milestone payments and royalty also bear the same risk as tests ateach phase.Total Payments to LAB = PV of Initial and Milestone Payment + PV of Royalty= 9.80 + 6.88= 16.68 (million)Table 7 - Payments to LABPhase Payment Probability of Success PV of PaymentInitial 5.00 100% 5.00Phase I Success 2.50 60% 1.50Phase II Depression 20.00 60%*10% 1.20Phase II Weight Loss 10.00 60%*15% 0.90Phase II Dual 40.00 60%*5% 1.20Total 9.80Loyalties Payment Probability of Success PV of PaymentDepression 1200*.05 5.10% 3.06Dual - depression 1200*.06 0.45% 0.27Weight Loss 345*.05 6.75% 1.16Dual - Weight Loss 345*.05 0.15% 0.03Dual 2250*.05 2.10% 2.36Total 6.88Conclusions and ConcernsOur evaluation was based on decision tree analysis and expected value computation. We estimated ten

potential outcomes from the three testing phases independently. Among them, there were five success and fivefailures. The sum of expected return from these ten outcomes was $13.69 million, which represented themaximum value Merck could get back from licensing Davanrik. Merck should have walked away if the bid

had gone over $13.69 million.There are concerns related to this investment. First, as the analysis indicated that there is high failure rateassociated with clinical testing and the FDA approval. The average rate of passing all tests and getting prooffrom the FDA is one out of 5000 or lower. Second, the clinical testing is seven-year long, and cost 200 to 350million dollars on average. Since Merck will not receive revenue or profit at least for seven years, the companyhas to face a lot of uncertainties, such as economic changes, government regulations and restrictions, andoperating risks in a long development period. Third, the testing could fail at any phase, which will lead tosubstantial costs. The costs will be $70 million or lower if it fails at the early stages, such as phase I or II. As

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the test fails at phase III, the losses will raise up from $220 million to $570 million. Overall, could Merck beara high risk investment with no return in at least seven year?ReferencesMerck & Company: Evaluating a Drug Licensing Opportunity , Harvard Business School, Case #9-201-023, March 25, 2003.