Merck & Company: Evaluating a Drug Licensing Opportunity

Topics: Black–Scholes, Real options analysis, Mathematical finance Pages: 4 (1029 words) Published: October 28, 2005
Should Merck license the compound?
Merck would be responsible for
1) the approval of Davanrik
2) the manufacture of Danavrik
3) marketing of Danavrik
Merck would pay LAB for
1) initial fee
2) royalty on all sales
3) make additional pymts as Danavrik completed each stage of approval process (3 Phases)
Additional facts:
approval process should take 7 years
patent will cover 17 years (7 of approval process nad 10 yr period of exclusivity beginning in yr 7) 1Assumptions:
All Cash flows are expressed as after tax present values discounted to time zero, including capital expenditures
At any point "failure," investment decision is to stop funding
Assuming Standard deviation of 0.5
Using T= 7 years in Black-Scholes Valuation

2Decision Tree
See worksheet "Decision Tree"

3Detailed description of Real Option Technique
"First, using a decision tree, I came up with a simple expected value of $13,980,000 based on the costs to complete each phase, the probabilities of completing each phase, and the costs and probabilities associated with failure at each step in the approval process. The expected value of successful completion with Depression only was $36,390,000, for weight only $1,200,000 and for both $26,880,000. The expected value of failure (including failure at any phase) was ($59,490,000). Next, I calculated the Valuations of each successful outcome using the decision tree analysis and the spectrum of outcomes with an asymetric distribution of rewards. Using the probability of 14.55%, which is the combined probability for any sucess, I recalculated the valuations of each success (Depression only, Depression only after testing for both in phase III, Weight only, etc). This gave me some drastically different valuations for those outcomes that had very small probabilities to begin with and ended with a summed expected value for the project of ($6,120,000). See the table below. "...
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