C L A S S N OT E A DA P T E D F RO M H A RVA R D B U S I N E S S S C H O O L

Merck & Company:

Evaluating a Drug Licensing Opportunity

Substantive Issues
The case explores the valuation of an opportunity to license a compound before it enters clinical trials and
describes Mercks decision tree evaluation process. It also provides information to evaluate a specific
licensing opportunity, including the costs of the three phases of the review process, the present value of
the revenues associated with successful outcomes, and the probability of various outcomes.

Pedagogical Opportunities
The primary pedagogical objective is to learn how to build and use decision trees to value uncertain
investment outcomes. The case analysis includes:

1. Determining how Merck generates sales/profits;

2. Assessing the value of licensing from licensor (LAB) and licensee (Merck) perspectives;

3. Constructing a decision tree to reflect timeline, cash flow, and probability;

4. Calculating expected values; and

5. Evaluating the opportunity for both companies.

The case highlights the use of probability in assessing the value and riskiness of a project or investment.

Suggested Classroom Plan

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?

Evaluate profit margins and ROIC (very large)

Understand costs involved in developing drugs and probabilities of getting a drug from
compound to marketing

Realize the large value extracted once a drug is approved and under patent protection

2. What are the potential outcomes for Davanrik?

202-001 Teaching NoteMerck & Company: Evaluating a Drug Licensing Opportunity

Describe FDA approval process

Build the decision tree based on the FDA approval

3. Should Merck license the drug? How much should it pay?

Discuss competitive issues in bidding for the drug (e.g. is anyone willing to pay $1
million more just to win the bid?)

4. How much should LAB expect to receive from the proposed deal?

Expected milestone payments

Expected royalty payments

Suggested Assignment Questions

1. How has Merck been able to achieve substantial returns to capital given the large costs and
lengthy time to develop drug?

2. Build a decision tree that shows the cash flows and probabilities at all stages of the FDA
approval process.

3. Should Merck bid to license Davanrik? How much should they pay?

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.

5. How would your analysis change if the costs of launching Davanrik for weight loss were $225
million instead of $100 million as given in the case?