Merck & Company: Evaluating a Drug Licensing Opportunity

COMPOUND SUCCESS RATES BY STAGES

Compound Success Rates by Stage

Discovery
(2-10 Years)

5,000-10,000 screened

Preclinical Testing
Laboratory and animal testing

250 enter preclinical testing

Phase I
20-80 healthy volunteers used to determine safety and dosage

5 enter clinical testing

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

13

Davanriks Potential Cash Flows

Phase I Tested on Tested for Time taken 20-80 healthy volunteers Safety 2 years Phase II (clinical testing) 100-300 of patient volunteers Effectiveness Potential side effect 2 years Phase III 1000-5000 of patients Safety and efficacy in long-term use 3 years

Cost

$30 million

$40 million

Depression: 200 mn Weight loss: $150 mn Both: $500 mn

Depression: 20 mn Weight loss: $10 mn Both: $40 mn

Initial fee / Milestone fee to LAB

$5 million

$2.5 million

14

Davanriks Potential Cash Flows

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

15

Davanriks Potential Cash Flows

Depression only Cost to launch Commercialization present value $250 million $1.2 billion Weight loss only $100 million $345 million Both $400 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 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

20

Value of Licensing to LAB

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

21

Decision Alternatives
Decision Alternatives Phase I (Safety) Success Failure Phase II (Efficacy) Depression Weight loss Both Failure Phase III (Long Term Use) Success Failure

23

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 II: Both

Phase III: Success

Depression
Weight loss

Phase III: Success Phase III: Failure Phase II: Failure Phase I: Failure

Do not License

Phase III: Success

Phase II: Depression

10%

85% Phase III: Failure 15% Phase III: Success

Phase II: Weight Loss 15% Phase I: Success 60%

75% Phase III: Failure 25% Phase III: Success 70% Both

In-License

Phase II: Both 5%

Phase III: Success 15% Phase III: Success 5% Phase III: Failure

Depression
Weight loss

Phase II: Failure Phase I: Failure 40% Do not License 70%

10%

Phase III: Success

Phase II: Depression

10% -$200

85%

-$250

Phase III: Failure 15% -$0 Phase III: Success

Phase II: Weight Loss 15% Phase I: Success 60% -$40 Phase II: Both 5% -$500 -$150

75%

-$100

Phase III: Failure 25% -$0 Phase III: Success 70% -$400 Both

In-License
-$30

Phase III: Success 15% -$250

Depression
Weight loss

Phase III: Success 5% -$100 Phase III: Failure

Phase II: Failure Phase I: Failure 40% Do not License -$0 -$0 70% -$0

10%

-$0

Phase III: Success

Phase II: Depression

10% -$200

85%

-$250

$1,200

Phase III: Failure 15% -$0 Phase III: Success

Phase II: Weight Loss 15% Phase I: Success 60% -$40 Phase II: Both 5% -$500 -$150

75%

-$100

$345

Phase III: Failure 25% -$0 Phase III: Success 70% -$400 Both $2,250

In-License
-$30

Phase III: Success 15% -$250

Depression $1,200
Weight loss $345

Phase III: Success 5% -$100 Phase III: Failure

Phase II: Failure Phase I: Failure 40% Do not License -$0 -$0 70% -$0

10%

-$0

Phase III: Success

Phase II: Depression

10%

85% Phase III: Failure 15% Phase III: Success

5.10%

0.90%

Phase II: Weight Loss 15% Phase I: Success 60%

75% Phase III: Failure 25% Phase III: Success 70%

6.75%

2.25%

Both 2.10%

In-License

Phase II: Both 5%

Phase III: Success 15% Phase III: Success 5% Phase III: Failure

Depression 0.45%

Weight loss 0.15%

Phase II: Failure Phase I: Failure 40% Do not License 70%

10%

0.30%

42% Total = 100%

40%

Phase III: Success

Phase II: Depression

10% -$200

85%

-$250

$1,200

$680 -$270

Phase III: Failure 15% -$0 Phase III: Success

Phase II: Weight Loss 15% Phase I: Success 60% -$40 Phase II: Both 5% -$500 -$150

75%

-$100

$345

$25 -$220

Phase III: Failure 25% -$0 Phase III: Success 70% -$400

Both $1280 $2,250

In-License
-$30

Phase III: Success 15% -$250

Depression $380 $1,200

Weight loss -$325 $345

Phase III: Success 5% -$100 Phase III: Failure

Phase II: Failure Phase I: Failure 40% Do not License -$0 -$0 70% -$0

10%

-$0

-$570

-$70

-$30

Phase III: Success

Phase II: Depression

10% -$200

85%

-$250

$1,200

$34.7 -$2.4

Phase III: Failure 15% -$0 Phase III: Success

Phase II: Weight Loss 15% Phase I: Success 60% -$40 Phase II: Both 5% -$500 -$150

75%

-$100

$345

$1.7 -$5.0

Phase III: Failure 25% -$0 Phase III: Success 70% -$400

$2,250

Both $26.90

In-License
-$30

Phase III: Success 15% -$250

Depression $1.7 $1,200

Weight loss -$0.5 $345

Phase III: Success 5% -$100 Phase III: Failure

Phase II: Failure Phase I: Failure 40% Do not License -$0 -$0 70%

10%

-$0

-$1.7

-$29.4 -$0 Total = $14.0

-$12.0

Davanriks Probability
Davanrik Failure Probability Phase Fail Probability Fail Probability Per Phase Total 40% I 40.00% 60% x 70% II 42.00% 60% x 10% x 15% III Depression 0.90% 60% x 15% x 25% III Weight Loss 2.25% III Dual Indication 60% x 5% x 10% 0.30% Total 85.45%
32 Phase III failure probability = 3.45%

Expected Value of Milestone Payments to LAB (Million of Dollars) Milestone Probability Payment (Millions) $5.00 100% 2.50 20.00 60% 60% x 10% Expected Milestone Payment $5.0 1.5 1.2

Initial
Phase I Success Phase II Depression

Phase II Weight Loss

10.00

60% x 15%
60% x 5%

0.9
1.2 9.8
34

Phase II Dual Indication 40.00 Total

Expected Value of Royalty Payments to LAB Gross CF Royalty Probability Expected (%) (%) Royalty $1263 5 5.10 $3.22 5 5 5 5 6.75 0.45 0.15 2.10 1.23 0.28 0.03 2.49 1263 363 2368

Depression Independent Claim Depression Dual Claim Weight Loss Dual Claim Dual Claim

Weight Loss Independent Claim 363

Total

14.55

7.25
35

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, 39 acceptance of any project would not alter the firms overall risk

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
40

Decision Analysis
Logical and systematic approach for analyzing decision problems Steps.,
Identify criteria for choosing among competitive alternatives Structure decision problem, listing alternatives and uncertain events in chronological order and representing them in a decision tree Assess the likelihood of the various uncertain events and assign values to the various outcomes of the decision problem Analyze the information provided in the first three steps to determine which alternative to undertake Determine if the decision is sensitive to changes in probabilities or other assumptions you have made
41

Decision Tree
Chronological sequence of options and uncertain events in a decision tree Maximizing expected monetary value (EMV) EMV = probability * net cash flow Outcome depends on external event making it uncertain Probabilities..,
Likelihood of uncertain events Precise numerical language for communicating judgments about the uncertain future Explicit in pronouncements Are formed based on researches
42

Decision Tree
Probability in DTA is objective Decision method folding back the tree or backwards induction Deals with uncertain inputs parameter values that are subject to uncertainty known only after a decision is made Probability tree Visual tool that can represent key elements in a model for decision making under uncertainty and help organize those elements by distinguishing between decisions 43 (controllable variables) and random events

Payoff Tables
Cost or revenue Is a measure of economic result Regret = for any state and any specific action, the regret is the monetary difference between the best possible payoff for that state and payoff for the specific action Expected value = weighted average outcome, where the weights are probabilities of each state States in Merck decision = 2 x 2 x 4 x 8 = 128
44

Decision Tree
Risk profile = distribution associated with a particular action Useful in situations where there are multiple sources of uncertainty and sequence of decisions to make Expected value of perfect information (EVPI) = measures the difference, or the gain due to perfect information
EVPI = measures the difference between certain payoff that could be realized under a condition of certainty and the expected payoff under a condition involving risk EVPI = EPC EMV EPC = expected payoff under certainty

45

Character of Decision Theory Problems

List of alternatives
Must be a set of ME and collectively exhaustive decision that are available to the decision maker

List of possible future states of nature

Set of possible future conditions, or events, beyond the control of the decision maker that will be the primary determinants of the eventual consequences of the decision Must be ME and collectively exhaustive

Payoffs associated with each alternative / state of nature combination

Estimated values Profits revenues costs other measure of value May be monthly daily yearly weekly May be present value of future cash flows

Assessment of the degree of certainty of possible future events Decision criterion

Maximize expected payoff Minimize opportunity cost
46

Approaches to Decision Making Under Complete Uncertainty

Maximin Maximax Minimax regret Hurwicz Equal likelihood

47

Deciding Between Projects with Same Present Value

Duration can be used
Duration = tPt / Pt
t = period Pt = cash flows received in a period

If interest rate is expected to increase (shift in yield curve and not a twist), should prefer investment with shorter duration, since its present value would decline by less as result of the interest rate increase and vice versa

48

Duration - Example
Discount Rate Time 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 8% 4 $160 200 350 395 432 440 442 444 446 448 450 451 451 452 (2,000) CF 5 280 280 280 280 280 280 280 280 280 280 280 280 280 280 280 8 ($350) (60) 60 350 700 1,200 2,250 4 148.15 171.47 277.84 290.34 294.01 277.27 257.90 239.88 223.11 207.51 193.00 179.10 165.83 153.89 -630.48 2448.82 448.82 PVCF 5 259.26 240.05 222.27 205.81 190.56 176.45 163.38 151.28 140.07 129.69 120.09 111.19 102.96 95.33 88.27 2396.65 tPVCF 8 4 5 8 -324.07 148 259 -350 -51.44 343 480 -120 47.63 834 667 180 257.26 1161 823 1400 476.41 1470 953 3500 756.20 1664 1059 7200 1312.85 1805 1144 15750 1919 1210 2008 1261 2075 1297 2123 1321 2149 1334 2156 1338 2154 1335 -9457 1324 2474.84 12552.27 15804.64 27560.00 Duration 5.13 6.59 11.14 49 396.65 474.84

NPV