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In 2000, Rich Kender, Vice President of Financial Evaluation and Analysis at Merck & Company was discussing the opportunity of investing in licensing, manufacturing and marketing of Davanrik, a drug originally developed to treat depression by LAB Pharmaceuticals. LAB proposed to sell the right of all the future profit made from the successful launch of Davanrik at the cost of an initial fee, royalty payments and additional payments as the drug completed each stage of the approval process. Merck & Company's organizational goal is to constantly refresh it's company's drug development portfolio and reach as many customers as possible during the patented time. So there was not only the potential of financial gain or quantitative aspect of the offer, but also the qualitative value which will be added by getting better positioning in the risky pharmaceuticals industry.
Presenting team analysis
The presenting team started out by giving a background about the industry and the companies. The main issue and financial terms were explained. However we feel that some of the assumptions such as Merck's flexibility to back out from building the plant in case of failure were not clearly mentioned. They failed to explain why Davanrik's market risk was lower than its stand alone risk. Discounted cash flow method which is the traditional financial tool for evaluating capital allocation was rejected without explanation. We can rationalize not using DCF for its inability to capture risk uncertainty. Passive investments such as stocks and bonds are good candidates to use DCF on. Once these investments are made investors cannot influence the cash flow generation. We agree that decision tree can be used to make preliminary judgment and real option analysis can be used to get more definitive answer. We think that sensitivity analysis and scenario analysis could have been useful since all inputs may change over time.
Merck's investment valuation
Decision tree approach: This approach is suitable for projects that do not have to be funded all at one time. The alternatives, probability of payoffs are identified using diagrams which are simple to understand and interpret with brief explanation giving important insights. It identifies managerial flexibility to reevaluate decisions using new information and then either invest additional funds or terminate the project.
Results of decision tree:
This analysis shows that the projects NPV as 13.37 million dollar. Our result is slightly different than the presenting team because of rounding. But both of our teams had positive NPV which suggest that the project should be accepted.
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Recommendation: Based on the forecast and profitability suggested by the finance team at Merck and Company the decision tree shows positive effect of Davanrik in its portfolio. Further investigations should be done if there are resources since decision tree result may fail if it is not revised periodically.
Real Option approach: Real option model are based on the assumptions that projects have underlying uncertainty such as the number of sales, variable costs or outcome of a research. The presenting team touched on how opportunities can be compared to managerial options. We would like to add that Merck's current situation can be analyzed using call option analysis where it can choose not to proceed with the project if it does not seem viable at any point. Any start up costs and fees incurred during this process is similar to the exercise price of a regular option. If the value of this option exceeds the cost of the option Merck should go ahead with this project.
It is important that managers always look for ways to create options. The followings are the options that are always common and can be evaluated through real option approach while estimating projects value.
Investment timing options:
Rich Kender should check if delaying the project can offset the harm that might cause for delaying. This option adds value by giving the managers more time to analyze the size of the market and viability of the research. One downside would be the threat of competitor companies developing similar product and creating market loyalty.
The opportunity of adding new products has been the strategic mission and competitive advantage of Merck & Company. Even though NPV analysis can show negative result with the current market condition, some projects add value to the company by reaching out to new customers.
Real option analysis considers the value of abandoning project which should be reflected while calculating the NPV.
Merck will have the option to alter its operations depending on the outcome of the project. It can increase capacity or cut down production depending on events.