Lessons from Pharmaceutical Product Litigation: Merck and the Vioxx Withdrawal, Cona & McDarby vs. Merck, Video Supplement Net Present Value (NPV) / MBA Resources

Introduction to Net Present Value (NPV) - What is Net Present Value (NPV) ? How it impacts financial decisions regarding project management?

NPV solution for Lessons from Pharmaceutical Product Litigation: Merck and the Vioxx Withdrawal, Cona & McDarby vs. Merck, Video Supplement case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Lessons from Pharmaceutical Product Litigation: Merck and the Vioxx Withdrawal, Cona & McDarby vs. Merck, Video Supplement case study is a Harvard Business School (HBR) case study written by Margaret L. Eaton. The Lessons from Pharmaceutical Product Litigation: Merck and the Vioxx Withdrawal, Cona & McDarby vs. Merck, Video Supplement (referred as “Merck Merck's” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, Ethics, Health, Product development, Regulation.

The net present value (NPV) of an investment proposal is the present value of the proposal’s net cash flows less the proposal’s initial cash outflow. If a project’s NPV is greater than or equal to zero, the project should be accepted.

NPV = Present Value of Future Cash Flows LESS Project’s Initial Investment

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Case Description of Lessons from Pharmaceutical Product Litigation: Merck and the Vioxx Withdrawal, Cona & McDarby vs. Merck, Video Supplement Case Study

In 2004, pharmaceutical powerhouse Merck acknowledged potentially harmful side effects and withdrew one of its best selling drugs, Vioxx, an arthritis and pain relief drug, from the market. Withdrawing an FDA approved drug from the U.S. market due to newly-discovered side effects was not so uncommon. What was unusual, however, was that Merck's withdrawal was a voluntary decision by the company after Vioxx had been taken by an estimated 80 million patients during four plus years on the market. While Merck's decision was initially hailed as an example of Merck's well known dedication to ethical business practices, some in the medical community instead accused Merck of intentionally keeping Vioxx on the market even though it was too dangerous. Critics claimed that Merck had put profits ahead of patients and Merck soon faced close to 30,000 product liability lawsuits. This case package consists of a written case, supporting written materials, and an accompanying case video which takes place in the courtroom of a trial against Merck. Tom Cona and John McDarby sued Merck after experiencing heart attacks that they attributed to Vioxx. Using trial footage supplied by Courtroom View Network, this case explores the kinds of wrongful conduct alleged and how companies like Merck defend themselves against such claims. The witnesses testifying in this trial include the patients and their families who are suing, Merck's CEO and senior management, the physicians who prescribed the drug, and those who were called to give expert testimony in support of and against Merck's drug development, regulatory, and marketing activities.Disk 1: Introduction to the trial & Opening statements Disk 2: Testimony in Plaintiffs' Case Disk 3: Testimony in Merck's Defense Disk 4: Closing Statements, Judge Instructions, Verdicts Disk 5: Review copy of case study, supplementary materials and slides from video presentation This material is designed to be used in a one-day seminar or equivalent, with students having read the written case study and watched Disk 1 prior to class. This case is particularly well suited for business, medical, and law students. The written materials and video are sold as a package and are designed to be used together. Academic faculty may request a teaching note. Please contact cases_requests@gsb.stanford.edu for permissions to use the written case each time it is taught.

Case Authors : Margaret L. Eaton

Topic : Strategy & Execution

Related Areas : Ethics, Health, Product development, Regulation

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Calculating Net Present Value (NPV) at 6% for Lessons from Pharmaceutical Product Litigation: Merck and the Vioxx Withdrawal, Cona & McDarby vs. Merck, Video Supplement Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10017471)	-10017471	-	-
Year 1	3470105	-6547366	3470105	0.9434	3273684
Year 2	3954840	-2592526	7424945	0.89	3519794
Year 3	3972436	1379910	11397381	0.8396	3335334
Year 4	3244037	4623947	14641418	0.7921	2569581
TOTAL			14641418		12698393

The Net Present Value at 6% discount rate is 2680922

In isolation the NPV number doesn't mean much but put in right context then it is one of the best method to evaluate project returns. In this article we will cover -

Different methods of capital budgeting

What is NPV & Formula of NPV,
How it is calculated,
How to use NPV number for project evaluation, and
Scenario Planning given risks and management priorities.

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Capital Budgeting Approaches

Methods of Capital Budgeting

There are four types of capital budgeting techniques that are widely used in the corporate world –

1. Payback Period
2. Net Present Value
3. Profitability Index
4. Internal Rate of Return

Apart from the Payback period method which is an additive method, rest of the methods are based on Discounted Cash Flow technique. Even though cash flow can be calculated based on the nature of the project, for the simplicity of the article we are assuming that all the expected cash flows are realized at the end of the year.

Discounted Cash Flow approaches provide a more objective basis for evaluating and selecting investment projects. They take into consideration both –

1. Timing of the expected cash flows – stockholders of Merck Merck's have higher preference for cash returns over 4-5 years rather than 10-15 years given the nature of the volatility in the industry.
2. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Merck Merck's shareholders have preference for diversified projects investment rather than prospective high income from a single capital intensive project.

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Formula and Steps to Calculate Net Present Value (NPV) of Lessons from Pharmaceutical Product Litigation: Merck and the Vioxx Withdrawal, Cona & McDarby vs. Merck, Video Supplement

NPV = Net Cash In Flowt1 / (1+r)t1 + Net Cash In Flowt2 / (1+r)t2 + … Net Cash In Flowtn / (1+r)tn
Less Net Cash Out Flowt0 / (1+r)t0

Where t = time period, in this case year 1, year 2 and so on.
r = discount rate or return that could be earned using other safe proposition such as fixed deposit or treasury bond rate. Net Cash In Flow – What the firm will get each year.
Net Cash Out Flow – What the firm needs to invest initially in the project.

Step 1 – Understand the nature of the project and calculate cash flow for each year.
Step 2 – Discount those cash flow based on the discount rate.
Step 3 – Add all the discounted cash flow.
Step 4 – Selection of the project

Why Strategy & Execution Managers need to know Financial Tools such as Net Present Value (NPV)?

In our daily workplace we often come across people and colleagues who are just focused on their core competency and targets they have to deliver. For example marketing managers at Merck Merck's often design programs whose objective is to drive brand awareness and customer reach. But how that 30 point increase in brand awareness or 10 point increase in customer touch points will result into shareholders’ value is not specified.

To overcome such scenarios managers at Merck Merck's needs to not only know the financial aspect of project management but also needs to have tools to integrate them into part of the project development and monitoring plan.

Calculating Net Present Value (NPV) at 15%

After working through various assumptions we reached a conclusion that risk is far higher than 6%. In a reasonably stable industry with weak competition - 15% discount rate can be a good benchmark.

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 15 %	Discounted Cash Flows
Year 0	(10017471)	-10017471	-	-
Year 1	3470105	-6547366	3470105	0.8696	3017483
Year 2	3954840	-2592526	7424945	0.7561	2990427
Year 3	3972436	1379910	11397381	0.6575	2611941
Year 4	3244037	4623947	14641418	0.5718	1854789
TOTAL					10474640

The Net NPV after 4 years is 457169

(10474640 - 10017471 )

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Calculating Net Present Value (NPV) at 20%

If the risk component is high in the industry then we should go for a higher hurdle rate / discount rate of 20%.

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 20 %	Discounted Cash Flows
Year 0	(10017471)	-10017471	-	-
Year 1	3470105	-6547366	3470105	0.8333	2891754
Year 2	3954840	-2592526	7424945	0.6944	2746417
Year 3	3972436	1379910	11397381	0.5787	2298863
Year 4	3244037	4623947	14641418	0.4823	1564447
TOTAL					9501481

The Net NPV after 4 years is -515990

At 20% discount rate the NPV is negative (9501481 - 10017471 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Merck Merck's to discount cash flow at lower discount rates such as 15%.

Acceptance Criteria of a Project based on NPV

Simplest Approach – If the investment project of Merck Merck's has a NPV value higher than Zero then finance managers at Merck Merck's can ACCEPT the project, otherwise they can reject the project. This means that project will deliver higher returns over the period of time than any alternate investment strategy.

In theory if the required rate of return or discount rate is chosen correctly by finance managers at Merck Merck's, then the stock price of the Merck Merck's should change by same amount of the NPV. In real world we know that share price also reflects various other factors that can be related to both macro and micro environment.

In the same vein – accepting the project with zero NPV should result in stagnant share price. Finance managers use discount rates as a measure of risk components in the project execution process.

Sensitivity Analysis

Project selection is often a far more complex decision than just choosing it based on the NPV number. Finance managers at Merck Merck's should conduct a sensitivity analysis to better understand not only the inherent risk of the projects but also how those risks can be either factored in or mitigated during the project execution. Sensitivity analysis helps in –

What can impact the cash flow of the project.

What are the key aspects of the projects that need to be monitored, refined, and retuned for continuous delivery of projected cash flows.

Understanding of risks involved in the project.

What are the uncertainties surrounding the project Initial Cash Outlay (ICO’s). ICO’s often have several different components such as land, machinery, building, and other equipment.

What will be a multi year spillover effect of various taxation regulations.

Some of the assumptions while using the Discounted Cash Flow Methods –

Projects are assumed to be Mutually Exclusive – This is seldom the came in modern day giant organizations where projects are often inter-related and rejecting a project solely based on NPV can result in sunk cost from a related project.

Independent projects have independent cash flows – As explained in the marketing project – though the project may look independent but in reality it is not as the brand awareness project can be closely associated with the spending on sales promotions and product specific advertising.

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Negotiation Strategy of Lessons from Pharmaceutical Product Litigation: Merck and the Vioxx Withdrawal, Cona & McDarby vs. Merck, Video Supplement

References & Further Readings

Margaret L. Eaton (2018), "Lessons from Pharmaceutical Product Litigation: Merck and the Vioxx Withdrawal, Cona & McDarby vs. Merck, Video Supplement Harvard Business Review Case Study. Published by HBR Publications.