NPV and IRR

1

Merck & Company:

Evaluating a Drug Licensing Opportunity

130 8 106 1412 1642

Discovery

Preclinical Testing

Phase I

Phase II

Phase III

FDA Review/Approval

AdditionalPost-marketing Testing

(2-10 Years)

Laboratory and animal testing

20-80 healthy volunteers used todetermine safety and dosage

100-300 patient volunteers usedto look for efficacy and side effects

1,000-5,000 patient volunteers used to monitoradverse reactions to long-term use.

Years

Compound Success

Rates by Stage

5,000-10,000screened

250enter preclinical testing

5enter clinical testing

Approved by the FDA

COMPOUND SUCCESS RATES BY STAGES

14

Davanrik’s PotentialCash Flows

Phase I Phase II(clinical testing)

Phase III

Tested on 20-80 healthy volunteers

100-300 of patient volunteers

1000-5000 of patients

Tested for Safety EffectivenessPotential side effect

Safety and efficacy in long-term use

Time taken 2 years 2 years 3 years

Cost $30 million $40 million Depression: 200 mnWeight loss: $150 mnBoth: $500 mn

Initial fee / Milestone fee to LAB

$5 million $2.5 million Depression: 20 mnWeight loss: $10 mnBoth: $40 mn

15


Phase I Phase II(clinical testing)

Phase III

Chance of success

60% Depression: 10%Weight loss: 15%Both: 5%

Depression: 85%Weight loss: 75%Both: 70%

Depression: 15%Weight loss: 5%Both: 10%

16


Depression only Weight loss only Both

Cost to launch $250 million $100 million $400 million

Commercialization present value

$1.2 billion $345 million $2.25 billion

All cash flows are expressed as after-tax present values discounted to time zero, including capital expendituresPresent value is calculated as the after-tax present value of 10 years worth of cash flows from the drug discounted back to today. It was believed that after 10 years,the drug had very little value to the company since it would be ‘off its patent’ by then(and thus a terminal value of zero was used in the calculations)

20

Value of Licensing to Merck

Source of compounds without risk, cost, and product development time of the discovery phaseMarshal a compound through phase testing by levering its expertise in the administrative and scientific requirements of the FDA processBring the product to the market place rapidly, making most of the limited time under patent protection

21

Value of Licensing to LAB

Cash flow in form of initial and milestone payments and sales royaltiesFocus on its competitive advantage and develop new compounds because of expert support in FDA approval

23

Decision Alternatives

Decision Alternatives

Phase I(Safety)

Phase II(Efficacy)

Phase III(Long Term Use)

Success Depression Success

Failure Weight loss Failure

Both

Failure

Phase I: Success

Phase I: Failure

In-License

Do not License

Phase II: Depression

Phase II: Weight Loss

Phase II: Both

Phase II: Failure

Phase III: Success

Phase III: Failure

Phase III: Success

Phase III: Failure

Phase III: Success

Phase III: Success

Phase III: Success

Phase III: Failure

Both

Depression

Weight loss

Phase I: Success

Phase I: Failure

In-License

Do not License



Phase II: Both

Phase II: Failure

Phase III: Success

Phase III: Failure

Phase III: Success

Phase III: Failure

Phase III: Success

Phase III: Success

Phase III: Success

Phase III: Failure

Both

Depression

Weight loss

60%

40%

10%

15%

5%

70%

85%

15%

75%

25%

70%

15%

5%

10%

Phase I: Success

Phase I: Failure

In-License

Do not License



Phase II: Both

Phase II: Failure

Phase III: Success

Phase III: Failure

Phase III: Success

Phase III: Failure

Phase III: Success

Phase III: Success

Phase III: Success

Phase III: Failure

Both

Depression

Weight loss

60%

40%

10%

15%

5%

70%

85%

15%

75%

25%

70%

15%

5%

10%

-$40

-$30

-$0

-$0

-$200

-$150

-$500

-$0

-$250

-$0

-$100

-$0

-$400

-$250

-$100

-$0

Phase I: Success

Phase I: Failure

In-License

Do not License



Phase II: Both

Phase II: Failure

Phase III: Success

Phase III: Failure

Phase III: Success

Phase III: Failure

Phase III: Success

Phase III: Success

Phase III: Success

Phase III: Failure

Both

Depression

Weight loss

60%

40%

10%

15%

5%

70%

85%

15%

75%

25%

70%

15%

5%

10%

-$40

-$30

-$0

-$0

-$200

-$150

-$500

-$0

-$250

-$0

-$100

-$0

-$400

-$250

-$100

-$0

$1,200

$345

$2,250

$1,200

$345

Phase I: Success

Phase I: Failure

In-License

Do not License



Phase II: Both

Phase II: Failure

Phase III: Success

Phase III: Failure

Phase III: Success

Phase III: Failure

Phase III: Success

Phase III: Success

Phase III: Success

Phase III: Failure

Both

Depression

Weight loss

60%

40%

10%

15%

5%

70%

85%

15%

75%

25%

70%

15%

5%

10%

40%42%

5.10%

0.90%

6.75%

2.25%

2.10%

0.45%

0.15%

0.30%

Total = 100%

Phase I: Success

Phase I: Failure

In-License

Do not License



Phase II: Both

Phase II: Failure

Phase III: Success

Phase III: Failure

Phase III: Success

Phase III: Failure

Phase III: Success

Phase III: Success

Phase III: Success

Phase III: Failure

Both

Depression

Weight loss

60%

40%

10%

15%

5%

70%

85%

15%

75%

25%

70%

15%

5%

10%

-$40

-$30

-$0

-$0

-$200

-$150

-$500

-$0

-$250

-$0

-$100

-$0

-$400

-$250

-$100

-$0

$1,200

$345

$2,250

$1,200

$345

-$30-$70

$680

-$270

$25

-$220

$1280

$380

-$325

-$570

Phase I: Success

Phase I: Failure

In-License

Do not License



Phase II: Both

Phase II: Failure

Phase III: Success

Phase III: Failure

Phase III: Success

Phase III: Failure

Phase III: Success

Phase III: Success

Phase III: Success

Phase III: Failure

Both

Depression

Weight loss

60%

40%

10%

15%

5%

70%

85%

15%

75%

25%

70%

15%

5%

10%

-$40

-$30

-$0

-$0

-$200

-$150

-$500

-$0

-$250

-$0

-$100

-$0

-$400

-$250

-$100

-$0

$1,200

$345

$2,250

$1,200

$345

-$12.0-$29.4

$34.7

-$2.4

$1.7

-$5.0

$26.90

$1.7

-$0.5

-$1.7

Total = $14.0

32

Davanrik’s Probability

Davanrik Failure Probability

Phase Fail Probability – Per Phase

Fail Probability Total

I 40% 40.00%II 60% x 70% 42.00%III – Depression 60% x 10% x 15% 0.90%III – Weight Loss 60% x 15% x 25% 2.25%III – Dual Indication 60% x 5% x 10% 0.30%Total 85.45%

Phase III failure probability = 3.45%

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Expected Value of Milestone Payments to LAB (Million of Dollars)

Milestone Payment(Millions)

Probability Expected Milestone Payment

Initial $5.00 100% $5.0

Phase I Success 2.50 60% 1.5

Phase II Depression 20.00 60% x 10% 1.2

Phase II Weight Loss 10.00 60% x 15% 0.9

Phase II Dual Indication 40.00 60% x 5% 1.2

Total 9.8

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Expected Value of Royalty Payments to LAB

Gross CF Royalty(%)

Probability(%)

ExpectedRoyalty

Depression – Independent Claim $1263 5 5.10 $3.22

Weight Loss – Independent Claim 363 5 6.75 1.23

Depression – Dual Claim 1263 5 0.45 0.28

Weight Loss – Dual Claim 363 5 0.15 0.03

Dual Claim 2368 5 2.10 2.49

Total 14.55 7.25

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Capital Budgeting Techniques

Traditional – Non risk based - Non-discounting techniques• Pay Back Period (PBP)• Accounting Returns on Investment (ARR)

Modern – Non risk based - discounting techniques• Net Present Value (NPV)• Internal Rate of Return (IRR)

» Multiple IRR» Modified Internal Rate of Return (MIRR)

• Present value Index (PI)• Equivalent Annuity (EA)

Non risk based techniques assumes that all projects were assumed to be equally risky,

acceptance of any project would not alter the firm’s overall risk

40

Capital Budgeting Techniques

Risk based techniques• Sensitivity analysis• Scenario analysis• Certainty equivalent model• Decision tree analysis• Break even analysis• Simulation• Risk adjusted discount rate• Real options

41

Decision Analysis

Logical and systematic approach for analyzing decision problemsSteps.,

• Identify criteria for choosing among competitive alternatives• Structure decision problem, listing alternatives and uncertain events

in chronological order and representing them in a decision tree• Assess the likelihood of the various uncertain events and assign

values to the various outcomes of the decision problem• Analyze the information provided in the first three steps to determine

which alternative to undertake• Determine if the decision is sensitive to changes in probabilities or

other assumptions you have made

42

Decision Tree

Chronological sequence of options and uncertain events in a decision treeMaximizing expected monetary value (EMV)EMV = probability * net cash flowOutcome depends on external event making it uncertainProbabilities..,

• Likelihood of uncertain events• Precise numerical language for communicating judgments about the

uncertain future• Explicit in pronouncements• Are formed based on researches

43

Decision Tree

Probability in DTA is objectiveDecision method – folding back the tree or backwards inductionDeals with uncertain inputs – parameter values that are subject to uncertainty – known only after a decision is madeProbability treeVisual tool that can represent key elements in a model for decision making under uncertainty and help organize those elements by distinguishing between decisions (controllable variables) and random events (uncontrollable variables)

44

Payoff Tables

Cost or revenueIs a measure of economic resultRegret = for any state and any specific action, the regret is the monetary difference between the best possible payoff for that state and payoff for the specific actionExpected value = weighted average outcome, where the weights are probabilities of each stateStates in Merck decision = 2 x 2 x 4 x 8 = 128

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Decision Tree

Risk profile = distribution associated with a particular actionUseful in situations where there are multiple sources of uncertainty and sequence of decisions to makeExpected value of perfect information (EVPI) = measures the difference, or the gain due to perfect information

• EVPI = measures the difference between certain payoff that could be realized under a condition of certainty and the expected payoff under a condition involving risk

• EVPI = EPC – EMV• EPC = expected payoff under certainty

46

Character of Decision Theory Problems

List of alternatives• Must be a set of ME and collectively exhaustive decision that are available to the decision

maker

List of possible future states of nature• Set of possible future conditions, or events, beyond the control of the decision maker that will

be the primary determinants of the eventual consequences of the decision• Must be ME and collectively exhaustive

Payoffs associated with each alternative / state of nature combination• Estimated values• Profits – revenues – costs – other measure of value• May be monthly – daily – yearly – weekly• May be present value of future cash flows

Assessment of the degree of certainty of possible future eventsDecision criterion

• Maximize expected payoff• Minimize opportunity cost

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Approaches to Decision Making Under Complete Uncertainty

MaximinMaximaxMinimax regretHurwiczEqual likelihood

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Deciding Between Projects with Same Present Value

Duration can be used• Duration = ΣtPt / ΣPt

» t = period» Pt = cash flows received in a period

• If interest rate is expected to increase (shift in yield curve and not a twist), should prefer investment with shorter duration, since its present value would decline by less as result of the interest rate increase and vice versa

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Duration - ExampleDiscount Rate 8%

4 5 8 4 5 8 4 5 81 $160 280 ($350) 148.15 259.26 -324.07 148 259 -3502 200 280 (60) 171.47 240.05 -51.44 343 480 -1203 350 280 60 277.84 222.27 47.63 834 667 1804 395 280 350 290.34 205.81 257.26 1161 823 14005 432 280 700 294.01 190.56 476.41 1470 953 35006 440 280 1,200 277.27 176.45 756.20 1664 1059 72007 442 280 2,250 257.90 163.38 1312.85 1805 1144 157508 444 280 239.88 151.28 1919 12109 446 280 223.11 140.07 2008 126110 448 280 207.51 129.69 2075 129711 450 280 193.00 120.09 2123 132112 451 280 179.10 111.19 2149 133413 451 280 165.83 102.96 2156 133814 452 280 153.89 95.33 2154 133515 (2,000) 280 -630.48 88.27 -9457 1324

2448.82 2396.65 2474.84 12552.27 15804.64 27560.00Duration 5.13 6.59 11.14

NPV 448.82 396.65 474.84

CF PVCF tPVCFTime

NPV and IRR

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