Merck & Co Evaluating a Drug Licensing Opportunity Case Solution

1. Decision Tree Analysis

Decision tree analysis is based on the following assumptions:

• Inflation is negligible due to which the time value of money impact is not significant.

• Objective of the company is to maximize its profits

• Given probabilities and cost estimates are correct

Management will only consider the next phase of the clinical process if the previous phase gives a positive expected value. Also, each phase of the process is analyzed independently. Backward induction method is applied in decision tree analysis that is one starts from the terminal node (represented by the blue arrow) value and roll backs step wise to reach the first decision node which in the case of Merck is “license the drug or not”. Expected payoff at each event node (represented by green circle) is calculated as:

Expected payoff = (prob. of success * payoff if successful) + (prob. of failure * payoff if failure)

At each decision node (represented by a yellow box), the maximum value is chosen from all the successor nodes coming out of the decision node because the objective of the company is to maximize profits. Based on the information and estimates available the NPV of the project using decision tree comes out to be 13.98 million.

Please refer to excel sheet ‘Decision Tree’ for detailed calculations. Following observations can be made from the decision tree:

• Positive NPV (13.98 million) suggests that Merck should go for the licensing of the drug as the project will add positive value to the company.

• Licensing bid value should be less than the Net present value calculated via decision tree.

• Project is of high risk-high reward type as the probability of failure increases up to 0.7 in phase 3