Merck & Company has been presented with an opportunity to invest $30 million for the purchasing rights of an obesity and high cholesterol lowering drug, KL-798 from Kappa Labs. Based on the expected probabilities of success through each product-development phase for this new drug, as well as the costs involved, the net present value of the project is -$1.16 million and is therefore recommended that Merck passes on the investment. Sensitivity analysis also show that adjusting the probabilities of successfully passing each approval process to more realistic expectations has a drastically negative affect on the project NPV.
Based on the decision tree model, it is recommended that Pat Harlow does not invest in the purchase of KL-798 from Kappa Labs assuming that the current payoffs and expected probabilities given currently are correct and do not change in the future. At the current decision point, during Phase I tests, there is an expected payoff of -$1.16 million based on the probabilities of success further in the future and expected returns. If Merck can negotiate either the price of KL-798 down by more than $1.16 million or reduce their contribution to complete Phase I testing, this could be an attractive option to invest in.
While this project is currently unfavorable, the length of this project and dependency on future variables makes the estimates of market value and probabilities of success very uncertain. From Graphs 1 and 2 in the Appendix, which depict which variables in the decision tree have the greatest impact on the project NPV, the estimated market value of KL-798 on the market, as well as the expected probabilities of passing Phase I and Phase II for the treatment of obesity and high cholesterol, have the largest impacts on whether or not the project is profitable. If Merck can put off making the investment until Kappa Labs has completed and passed Phase I testing, the decision tree indicates that Merck would be