Harvard Business School Case
Merck & Co.: Evaluating a Drug Licensing Opportunity
Summary:
Merck & Co. has been approached by LAB Pharmaceuticals with a proposal for Merck to design, administer, and fund the clinical testing of their new compound, Davanrik. Davanrik has the potential to stimulate the receptor that promotes antidepression and block the receptor that causes hunger. Merck would have to make payments to LAB as Davanrik proceeds through the FDA’s approval process in addition to shelling out millions in costs for the testing. Davanrik could prove to be effective for only antidepression, only weight loss, or both. If Davanrik gets approved for any of these scenarios, each has its own launch costs and expected revenue over the 10 year period of exclusivity. Using statistical analysis, we plan to show the expected risks and payoffs Merck can anticipate if it were to move forward with supporting LAB Pharmaceutical and Davanrik.
Analysis:
Using a decision tree analysis (see attached), we determined that the expected payoff from Merck is $13,980,000. This expected payoff is the sum product of all 10 possible outcomes if Merck decides to proceed with Phase 1 of the FDA approval process for Davanrik. Given the small probability of success of each of the five success outcomes, the probability that Merck will lose money on Davanrik is 85.45%. We arrived at this answer by adding together all of the probabilities that Davanrik does not make it through the FDA approval process.
In addition to having a fairly low expected payoff for Merck, given the hundreds of millions of costs involved, we find that the proposal is highly risky. Finding the variances of each outcome, summing them, and taking the sum’s square root we find that the investment has a standard deviation of $252,550,163. This indicates that a range of ($238,660,163) through $266,440,163 represents only 1 standard deviation from the mean and 68% of the possible values. There are multiple stages in the approval process that Davanrik could fail to be approved by the FDA, and the further along in the process Davanrik gets before it fails the more money Merck stands to lose.
Based on our results listed above of Davanrik’s low expected payoff and high standard deviation that represents riskiness, we recommend that Merck should not move forward with the investment in Davanrik. There is simply too high of a probability that Merck will end up losing tens of millions of dollars.
