Problem Definition

Should Rich Kender recommend licensing Davanrik, making Merck & Company responsible for its manufacture and its marketing?

In order to provide Rich Kender with a good and thorough analysis and recommendation on the Davanrik licensing project, we need to answer the following guidance questions:

I. How has Merck been able to achieve substantial returns to capital given the large costs and lengthy time to develop drugs?

II. How much should they pay?

III. What is the expected value of the licensing arrangement to LAB?

IV. How would our analysis change if the costs of launching Davanrik for weight loss were $225 million instead of $100 million?

In our analysis we will build a decision tree that shows the cash flows and probabilities at all stages of the FDA approval process. We will assume a royalty fee of 5% on the cash flows that Merck receives from Davanrik after successful launch.

Analysis

Merck is in the business of developing compounds for pharmaceutical compounds. The required research and development efforts preceding the launch of a successful blockbuster drug is extensive and lengthy process and is therefore a very expensive one. Nevertheless, Merck has proven perfectly capable to achieve high returns on capital. This is a result of numerous factors.

First of all, Merck has been able to generate tremendous amounts of sales. Since 1995, Merck has launched 15 new products, resulting in 1999 sales of $32.7 billion, which includes $15.2 billion in pharmaceutical benefit management services (PBM) sales. Some products were developed through joint ventures, allowing for a division of costs but also future revenues.

Furthermore, these new products are protected by law under patents, which give Merck the exclusive rights to the production and sales. Since Merck is then the only manufacturer of a substance,