Real Options and Financial Structuring - Case Study 3
Merck and Company
Hallgerður Helga Þorsteinsdóttir, Léo Lenel, Thibaud Vincent, Tristan Buchs
19th December 2016
1 Merck’s revenues
Merck and Co. is a global research driven pharmaceutical company that discovers, develops, man-
ufactures and markets wide variety of health products, along with providing pharmaceutical benefit
management services (PBM). It is costly and time consuming to develop drugs, but Merck manages to
achieve substantial returns to capital despite that.
In the last 5 years, Merck&Co. has launched 15 new products. While they have the exclusivity on
those drugs due to the fact that they hold the patent, they generate substantially higher returns than
its competitors. After releasing the patents, the company loses its advantage as others start to produce
generic substitutes. Thus it is important for Merck to develop and bring a product to the market as
fast as possible, in order to get the longest patent protected selling period. A large part of Merck’s
returns come from the PBM services, that is a steadier, less risky business than trying to develop drug
and get a patent for it. For the last few years, they have had a few popular patented drugs which have
been bringing in profitable returns, but the bad news is that many of those patents will expire in 2002.
Therefore, Merck needs to take actions and continue to develop their "portfolio" of potential patented
successful drugs.
2 Decision Tree
A decision tree that illustrates cash flows and probabilities at all stages of the FDA approval process is
depicted in Figure 1. Note that all cash flows are expressed as an after-tax present values discounted to
time zero. We observe that the tree is path dependant. At each end node of the tree, we can find three
distinct element:
• Total Probability: (pink) For each end-node the total probability is calculated by multiplying
each probability in the relevant path together. As an example the top box in Phase III, Depression,
has a probability of being reached: 60% ∗ 10% ∗ 85% = 5.1%
• Total Cost/Profit: (green) For each end-node the total cost/profit is calculated by summing each
cost/profit in the relevant path together. As an example, the top box in Phase III, Depression, has
the total profit of : −$30M − $40M − $200M + $1200M = $680M . In this case the future present
value of a successful depression drug weights the most, for this node to have a positive final value.
• Expected Cost/Profit: (purple) For each end-note the expected cost/profit is calculated by
multiplying the total probability with the total cost/profit for that path. As an example the top
box in Phase III, Depression, has the expected value of : 5.1% ∗ $680M = $34.68M
3 Should Merck bid to license Davanrick?
We look at the results from Figure 1 and add together all the expected cost/profit end nodes. The
expected value of the project is $13.98M . Since the project has positive expected value and fits into
Merck’s business needs, they should license Davanrick. They should not pay more than $13.98M .
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Real Options and Financial Structuring - Case Study 3 Hallgerður, Léo, Thibaud, Tristan
Figure 1: Decision Tree - Merck
4 SAB
The total value of the licensing agreement is composed of payments for each phase entered, and the 5%
royalty fees on any cash flow Merck receives from Davanrick after a successful launch. The results are
depicted in Figure 2 and the expected value of the agreement is the total sum of "Expected Cost/Profit"
and is $17.04M .
Let us take as an example again the top box in Phase III, Depression, to show how we calculated the
the expected value of licensing the agreement to LAB.
• Payment for entering each phase: Amounts stated in description of the deal, LAB gets in
total: $5M + $2.5M + $20M = $27.5M
• Royalty payment: Calculated from the cash flow that Merck receives at each end node, assuming
it is 95% of the total amount. The royalty fees for LAB are the last 5% so in our end node, LAB’s
royalty fee equals: ($1200M/95) ∗ 5 = $63.16M
• In total:The probabilities are still the same as in Figure 1. Total cost/profit is the sum of the
payments of entering each phase and the royalty fees: $27.5M +$63.16M = $90.66M The expected
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Real Options and Financial Structuring - Case Study 3 Hallgerður, Léo, Thibaud, Tristan
value: $90.66 ∗ 5.1% = $4.62M
Figure 2: Decision Tree - SAB
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