Davanrik is a new drug developed by LAB Pharmaceuticals, which has the potential to treat depression and obesity. Davanrik was initially developed to treat depression by stimulating the receptor in the serotonin system that promotes anti-depression. However, it was discovered that Davanrik also blocks the receptor that causes hunger. LAB Pharmaceuticals obtained a patent for Davanrik with a max remaining life of 17 years.
LAB Pharmaceuticals is a small and relatively new (15 years) company in the pharmaceutical field. LAB Pharmaceuticals has never had any of their compounds successfully complete the FDA approval process and in a response to a denial of a recent compound, the company’s stock dropped by over 30%.
In 2000, needing an in-flow of cash and also lacking the resources to complete the time-consuming FDA approval process, LAB Pharmaceuticals approached Merck & Co., a research-driven pharmaceutical company with presence in the global market, with an offer to license the Davanrik compound. In the terms of the license, Merck would be responsible for the approval process, the manufacturing, and the marketing of the drug.
This opportunity is one to consider for Merck because of their expiring patents on four of their most popular drugs in 2002.
Merck’s evaluation team estimates that the approval process will take a total of seven years. With the 17-year life of the patent, this gives Merck 10 years of exclusivity. The financial team also estimates the likelihood and costs of completing each step in the approval process (see tree-diagram below). Their forecast predicts large profits if Davanrik can effectively treat both depression and obesity ($2.25 billion present value with $400 million cost). The forecast for the treatment of depression only is a cost of $250 million with a present value of $1.2 billion and the treatment of weight-loss only is a cost of $100 million and a present value of $345 million.
1. How has Merck been able to achieve substantial returns on capital given the large costs and lengthy time to develop drugs? – Merck is able to achieve this by developing new drugs in-house and obtaining patents that provide a substantial period of initial exclusivity. By continuing in their development of new drugs, the company is able to refresh their company’s portfolio as patents on previous drugs expire. This helps Merck avoid a loss of sales from generic substitutions that become available after the life of a patent on certain drugs expires. This cycle, along with their resources and initiatives with biotechnology companies ensures that Merck has a competitive advantage in the pharmaceutical field.
2. Build a decision tree that shows the cash flows and probabilities at all stages of the FDA approval process. – See Appendix below
3. Should Merck bid to license Davanrik? How much should they pay? – Merck should bid to license Davanrik as the total NPV of all the outcomes comes out to be $13.98 million, a positive amount. A positive NPV indicates a positive future cash flow and should be taken. Merck should consider paying any amount that negotiations decide as long as it does not exceed $13.98 million.
4. What is the expected value of the licensing arrangement to LAB? Assume a 5% royalty fee on any cash flows that Merck receives from Davanrik after a successful launch.