1. How has Merck been able to achieve substantial returns to capital given the large costs and lengthy time to develop a new drug?
Merck had a 14% increase in sales between 1997 and 1998 and 22% increase in sales from 1998 – 1999, and a 13% annual increase in earnings over the same period. Merck’s business strategy consists of two parts: (1) developing and marketing new drugs through internal research, and (2) developing partnerships with smaller biotechnology companies. Since 1995, Merck had launched 15 new products that earned $5.9 billion on sales of $32.7 billion. Furthermore, Merck may agree to license new drugs from other firms and with its larger capital and greater assets, can assume the risk of submitting the drug through various regulatory approval phases. If the drug becomes profitable, Merck can earn significant cash flows while paying a royalty to the licensor. However, most important is the option that Merck has in deciding when to abandon or continue on this project (deferability or optionality). If Merck reaches a point when its expected NPV is negative, it can simply abandon the project.
As a licensee, Merck can allow smaller biotechnology firms to focus on research and development. These smaller firms often have smaller budgets and are not financially or personnel equipped to handle the costly and long FDA approval process, and the subsequent marketing, distribution, and sales of new drugs. This task is better suited for a larger company, such as Merck, which has more resources and money.
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 Merck pay?
Using the decision tree with the cash flows and the probability of each scenario, we calculated the expected net value of this drug license to be $13.98 million at year 2000 (Appendix 1). In addition, Merck’s patents on its current drugs will soon