Negotiating Partnerships in the Healthcare Industry (B): The Pharmac and Respire Deal 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 Negotiating Partnerships in the Healthcare Industry (B): The Pharmac and Respire Deal case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Negotiating Partnerships in the Healthcare Industry (B): The Pharmac and Respire Deal case study is a Harvard Business School (HBR) case study written by Stefanos Zenios, Robert Chess, Sara Gaviser Leslie, Lyn Denend. The Negotiating Partnerships in the Healthcare Industry (B): The Pharmac and Respire Deal (referred as “Pharmac Respire” from here on) case study provides evaluation & decision scenario in field of Leadership & Managing People. It also touches upon business topics such as - Value proposition, Negotiations.

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 Negotiating Partnerships in the Healthcare Industry (B): The Pharmac and Respire Deal Case Study

This case has been developed to facilitate a negotiation exercise related to the formation of partnership deals in the healthcare industry. It is based on actual information, but reflects a hypothetical situation involving two companies and a product that have all been disguised. The scenario described within the case involves Pharmac, a large pharmaceutical company, and Respire, a small medical start-up. Pharmac and Respire began negotiating a partnership to develop and eventually market an inhaled form of parathyroid hormone (PTH) to treat osteoporosis. If successful, this product would improve the available options for the treatment of osteoporosis. It was also expected to produce "blockbuster" sales since it would make PTH, an already extremely effective treatment option, more convenient and appealing to a large segment of untreated patients who were injection-averse (injection was the standard delivery mechanism for this drug). Development of the product was highly speculative and was expected to take six to seven years due to early stage development of the inhalable delivery system and the multi-year Phase III fracture trials required for approval. Pharmac had released the first man-made, injectable form of parathyroid hormone, called Strocal, in 2002. However, no one had yet developed a non-injectable version of PTH, despite efforts by Pharmac and other companies that spanned more than a decade. Respire's goal was to be the first company to solve this problem by developing an inhaled formulation and a device to deliver Strocal through the lungs in a safe, effective, and reproducible manner. Enough information is provided within the case to enable students to negotiate terms for royalties, milestones, exclusivity provisions, and an equity investment. At the end of OIT-81A, information known to Pharmac (but not to Respire) is provided. In OIT-81B, information known to Respire (but not to Pharmac) is given.

Case Authors : Stefanos Zenios, Robert Chess, Sara Gaviser Leslie, Lyn Denend

Topic : Leadership & Managing People

Related Areas : Negotiations

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Calculating Net Present Value (NPV) at 6% for Negotiating Partnerships in the Healthcare Industry (B): The Pharmac and Respire Deal Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10019591)	-10019591	-	-
Year 1	3446163	-6573428	3446163	0.9434	3251097
Year 2	3971183	-2602245	7417346	0.89	3534339
Year 3	3955347	1353102	11372693	0.8396	3320986
Year 4	3224462	4577564	14597155	0.7921	2554076
TOTAL			14597155		12660497

The Net Present Value at 6% discount rate is 2640906

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

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Formula and Steps to Calculate Net Present Value (NPV) of Negotiating Partnerships in the Healthcare Industry (B): The Pharmac and Respire Deal

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 Leadership & Managing People 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 Pharmac Respire 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 Pharmac Respire 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	(10019591)	-10019591	-	-
Year 1	3446163	-6573428	3446163	0.8696	2996663
Year 2	3971183	-2602245	7417346	0.7561	3002785
Year 3	3955347	1353102	11372693	0.6575	2600705
Year 4	3224462	4577564	14597155	0.5718	1843597
TOTAL					10443750

The Net NPV after 4 years is 424159

(10443750 - 10019591 )

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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	(10019591)	-10019591	-	-
Year 1	3446163	-6573428	3446163	0.8333	2871803
Year 2	3971183	-2602245	7417346	0.6944	2757766
Year 3	3955347	1353102	11372693	0.5787	2288974
Year 4	3224462	4577564	14597155	0.4823	1555007
TOTAL					9473549

The Net NPV after 4 years is -546042

At 20% discount rate the NPV is negative (9473549 - 10019591 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Pharmac Respire 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 Pharmac Respire has a NPV value higher than Zero then finance managers at Pharmac Respire 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 Pharmac Respire, then the stock price of the Pharmac Respire 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 Pharmac Respire 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 are the key aspects of the projects that need to be monitored, refined, and retuned for continuous delivery of projected cash flows.

What can impact the cash flow of 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.

Understanding of risks involved in the project.

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 Negotiating Partnerships in the Healthcare Industry (B): The Pharmac and Respire Deal

References & Further Readings

Stefanos Zenios, Robert Chess, Sara Gaviser Leslie, Lyn Denend (2018), "Negotiating Partnerships in the Healthcare Industry (B): The Pharmac and Respire Deal Harvard Business Review Case Study. Published by HBR Publications.