Merck Corporation Harvard Business Case

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Introduction

Merck’s Vise President of Financial Evaluation & Analysis, Rich Kender, was working with his team to decide whether his company should license Davanrik, a new drug developed by LAB Pharmaceuticals to treat both depression and obesity. LAB, which lacked of resources to complete Davanrik’s lengthy and complicated pre-market processes had approached Merck with an offer to license the drug. Under the agreement, Merck would be in charge of the approval of Davanrik, its manufacture, and its marketing. In addition, Merck would need to pay LAB an initial fee, a royalty on all sales, and make payments as Davanrik completed each state of the approval process. In the remainder of this report, I will begin by

Analysis of Financial Ratios

In 2000, Merck & Co., Inc was a global research-driven pharmaceutical company that had successfully launched 15 new products including Vioxx, Fosamax, Singularir, and many more since 1995. The company’s net income had about a 20% increase from $5.2 billion in 1998 to $5.8 billion in 1999. Appendix 1 contains Merck’s financial ratios from 1997 to 1999. The current ratios being greater than 1 in both years show the company’s ability to meet its short-term obligations using its current assets. The net profit margin of being roughly 20% shows Merck’s high profitability from the sales of patent drugs. Its returns on assets and equity also demonstrate management’s efficiency on utilizing its resources. From 1998 to 1999, Merck’s debt to equity ratio rose almost about 14% and the fact that both ratios being greater than one shows that the company was a leveraged firm rather than a conservative one. The reason being is that Merck heavily depended on the sales of its patent drugs, however, once the patents expired, Merck anticipated the sale for these drugs to decline substantially due to generic substitutes from other competitors in the market became available. Therefore, in order to counter the loss of sales from drugs going off patent, Merck needed to constantly refresh its portfolio by developing and investing in new drugs. However, this also ran the risk of failing to launch a drug could substantially hinder the company’s financial further more.

Merck’s Decision Tree

In order to determine whether or not Merck should license Davanrik, we built a decision tree that shows the cash flows and probabilities at all stages of the FDA approval process, as shown in Appendix 2. We calculated the expected monetary value for licensing Davanrik to be $13.98 million as shown in Appendix 3. Because of the positive value this project can bring, we suggest that Merck should bid to license Davanrik and as long as its payment to LAB did not exceed $13.98 million, it would be a profitable project for Merck. The only thing that Merck might need to be concerned was the low success rate of the entire project being at only 14.55%. This would definitely increase the risk of Merck’s investment and should be evaluated and assessed closely by Merck’s management.

Expected Value of the Licensing Agreement

Merck and LAB had a licensing agreement, which stated that Merck was responsible for paying LAB a number of fees contingent upon the outcome of each stage through out the entire process. Under the assumption that LAB received a 5% royalty fee on any cash flows that Merck received from Davanrik after a successful launch in addition to the licensing fees, we recalculated Merck’s NPV of the project simply by taking out 5% of the final cash inflows, as shown in Appendix 4, which came out to be $7.1 Million. The reduction in the final cash inflows clearly took a toll on the overall profitability of the project.

Now let’s switch to the other side and look at what LAB could potentially gain from the project. In order to determine the expected value of the licensing agreement from LAB’s perspective, we constructed a second decision tree with the adjusted cash flows, as shown in Appendix 5. Based on our calculation, as shown in Appendix 6, we concluded that LAB could expect to receive $16.68 million from the licensing and royalty fees on any successfully launch without any costs or expenditures.

More Assumptions

So now suppose the costs for launching Davanrik for weight loss were $225 million instead of $100 million used in the calculation above, as shown in Appendix 7, we simply made this change in the excel model and the expected value highlighted in yellow instantly dropped to $5.54 million from the previous $13.98 million. This shows that higher launching costs can have a significant impact on the overall return on the project. In this case, the increase in the launching costs was able to cut the value of the project almost by half. This is something that should obtain management’s attention that the project was largely cost driven and the company should try to reduce the launching costs in order to maximize profit. Another option is that Merck could look for other projects to invest in.