Strategy in the 21st Century Pharmaceutical Industry: Merck & Co. and Pfizer Inc. 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 Strategy in the 21st Century Pharmaceutical Industry: Merck & Co. and Pfizer Inc. case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Strategy in the 21st Century Pharmaceutical Industry: Merck & Co. and Pfizer Inc. case study is a Harvard Business School (HBR) case study written by David J. Collis, Troy Smith. The Strategy in the 21st Century Pharmaceutical Industry: Merck & Co. and Pfizer Inc. (referred as “Pharmaceutical Pfizer” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, International business.

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 Strategy in the 21st Century Pharmaceutical Industry: Merck & Co. and Pfizer Inc. Case Study

The global pharmaceutical industry has gone through substantial changes in the last few decade and pharmaceutical firms face major challenges, including headline-grabbing litigation, imminent patent expirations, new technologies, rising drug development costs, generic drug substitution, international competitors, and complex public policy issues. Describes the pharmaceutical industry in 2006, including: the drug development process; threats from biotech and generics competitors; pharmaceutical manufacturing, selling, and marketing; and pharmaceutical consumption in Europe, the third world, and the U.S. Merck and Pfizer are analyzed in-depth and a contrast between Merck, as a research-based firm opposed to mergers, and Pfizer, as a marketing powerhouse growing through acquisitions, is developed. Thirteen exhibits give concrete focus to the issues of the case.

Case Authors : David J. Collis, Troy Smith

Topic : Strategy & Execution

Related Areas : International business

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Calculating Net Present Value (NPV) at 6% for Strategy in the 21st Century Pharmaceutical Industry: Merck & Co. and Pfizer Inc. Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10006617)	-10006617	-	-
Year 1	3466047	-6540570	3466047	0.9434	3269856
Year 2	3956339	-2584231	7422386	0.89	3521128
Year 3	3961016	1376785	11383402	0.8396	3325745
Year 4	3240736	4617521	14624138	0.7921	2566966
TOTAL			14624138		12683695

The Net Present Value at 6% discount rate is 2677078

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. Internal Rate of Return
4. Profitability Index

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 Pharmaceutical Pfizer 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. Pharmaceutical Pfizer 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 Strategy in the 21st Century Pharmaceutical Industry: Merck & Co. and Pfizer Inc.

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 Pharmaceutical Pfizer 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 Pharmaceutical Pfizer 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	(10006617)	-10006617	-	-
Year 1	3466047	-6540570	3466047	0.8696	3013954
Year 2	3956339	-2584231	7422386	0.7561	2991561
Year 3	3961016	1376785	11383402	0.6575	2604432
Year 4	3240736	4617521	14624138	0.5718	1852901
TOTAL					10462848

The Net NPV after 4 years is 456231

(10462848 - 10006617 )

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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	(10006617)	-10006617	-	-
Year 1	3466047	-6540570	3466047	0.8333	2888373
Year 2	3956339	-2584231	7422386	0.6944	2747458
Year 3	3961016	1376785	11383402	0.5787	2292255
Year 4	3240736	4617521	14624138	0.4823	1562855
TOTAL					9490940

The Net NPV after 4 years is -515677

At 20% discount rate the NPV is negative (9490940 - 10006617 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Pharmaceutical Pfizer 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 Pharmaceutical Pfizer has a NPV value higher than Zero then finance managers at Pharmaceutical Pfizer 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 Pharmaceutical Pfizer, then the stock price of the Pharmaceutical Pfizer 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 Pharmaceutical Pfizer 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 will be a multi year spillover effect of various taxation regulations.

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.

Understanding of risks involved in the project.

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.

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 Strategy in the 21st Century Pharmaceutical Industry: Merck & Co. and Pfizer Inc.

References & Further Readings

David J. Collis, Troy Smith (2018), "Strategy in the 21st Century Pharmaceutical Industry: Merck & Co. and Pfizer Inc. Harvard Business Review Case Study. Published by HBR Publications.