Estimating the Value
`of a Drug in Development
`
`THIS CASE Vv’AS Vx/RITTEN BY EIEATHER FREEMAN (MERCK) AND SEAN NICHOLSON IN 2004.
`
`Depomed Exhibit 2087, Page 1 of 12
`
`Depomed Exhibit 2087, Page 1 of 12
`
`

`
`INTRODUCTION
`
`Imagine it is Fall 2003, and you are a financial executive working in the Research Division of a
`large pharmaceutical company. The company’s Director of Research and Development,
`Melissa, is formulating her recommendations regarding which drugs and chemical compounds
`the company should continue to develop and which should be terminated, based on their
`scientific merit and commercial potential. One of the drug candidates under consideration,
`referred to internally as ABC 551, is currently in the preclinical stage and is intended to treat
`depression and anxiety disorders. The company has a large number of products in development,
`and Melissa must determine whether ABC 551 ’s expected commercial payoff is high enough to
`justify allocating resources to the drug’s further development. Your assignment is to help
`Melissa evaluate ABC 55 l.
`
`In order to assess ABC 551, it is necessary to be familiar with the depression and anxiety
`markets in which the drug will compete if it is successfully developed and approved for sale.
`The Marketing Department has provided you with an overview that describes the prevalence of
`depression and anxiety, existing treatments, unmet needs, and products currently under
`development (see pages 2-6). Likewise, the company’s scientists have provided a brief synopsis
`of ABC 55l’s medical attributes (page 7), based on the initial research and preclinical testing
`that has been conducted to date.
`
`OVERVIEVV OF THE DEPRESSION AND ANXIETY MARKETS
`
`The Depression Market
`
`Depression is the second most common mental health disorder (after anxiety). The U.S.
`National Institute of Mental Health estimated that l8.8 million American adults suffered from a
`
`depressive disorder in 2002, and the World Health Organization estimated the 2001 global figure
`to be l2l million, including adults and children.1 Each year about ten percent of the US.
`population experiences depression severe enough to require medical attention? Only a third to a
`half of adults suffering from depression seek treatment.3
`
`Drug therapy is the most commonly used method of treating depression; about half of the time,
`drug therapy is used in combination with psychotlierapyfl Antidepressant drugs work by
`regulating the levels of chemicals in the brain that affect mood and pleasure (specifically,
`serotonin, norepinephrine, and/or dopamine). Numerous therapeutic options are currently
`available, including trieyclic antidepressants, monoarnine oxidase inhibitors (MAOIs), and
`selective serotonin reuptake inhibitors (S SRls). In addition, several recent entrants employ dual
`mechanisms of action or regulate chemical receptors more selectively. Exhibit 1 presents an
`overview of the major categories of antidepressant drugs.
`
`SSRIS such as Paxil, Zoloft, Celexa, and Prozac are currently the most commonly used class of
`antidepressants. Paxil and Zoloft are the market leaders in the depression market — both had U.S.
`
`1 Decision Resources, Inc. “Antidepressants and Anxiolytics: Expanded Indications Fueling Market Growth,” 2003.
`2 National Institute of Mental Health, “Depression,” 2002. (At www nimh nih. Iov/ rrblicat/de ressioncfm)
`3 Decision Resources, Inc. (Ibid.)
`4 Olfson et
`“National Trends in the Outpatient Treatment of Dcpressiorr” JAJ44, Vol. 287, No, 2, 2002.
`
`Depomed Exhibit 2087, Page 2 of 12
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`Depomed Exhibit 2087, Page 2 of 12
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`

`
`sales of approximately $2.5 billion in 2002. The older tricyclic and MAOI classes are used less
`frequently, due to their side effect profiles. Tricyclics often cause sedation, weight gain, sexual
`dysfunction, and cardiovascular risk; they have serious, potentially life-threatening toxicity in
`overdose. MAOIs require very strict dietary restrictions and cannot be used with many other
`types of drugs, or stroke can result. SSRIS have similar efficacy as tiicyclics and MAOIS, but
`tend to have more tolerable side effects (e. g., nausea, diarrhea, weight loss, and headache).
`SSRIS also can cause sexual dysfunction, which is considered one of the most significant
`shortcomings of the class. Drugs that target multiple chemical receptors, such as Effexor,
`Wellbutrin, and Remeron, achieve similar efficacy as the other classes while mitigating some
`side effects or increasing the speed of onset. Most antidepressants must be taken for several
`weeks before they begin to work. The probability that any given antidepressant will be effective
`for a particular patient is about 65 percent. 5 When treatment with one drug fails to relieve
`depression, another drug (in either the same or a different class) or a combination of drugs may
`be effective.
`
`The Anxiety Market
`
`The major anxiety disorders include generalized anxiety disorder, panic attacks, phobias,
`obsessive-compulsive disorder, and posttraumatic stress disorder. Anxiety disorders are more
`common than any other type of mental health disorder and are believed to affect about 15 percent
`of adults in the United States.6 According to the Anxiety Disorders Association of America,
`anxiety disorders affect approximately 19 million American adults.
`It is estimated that more
`than 87 million people in the seven major pharmaceutical markets (United States, France,
`Germany, Italy, Spain, United Kingdom, and Japan) suffer from anxiety disorders. Many of
`these people are not properly diagnosed, diagnosis rates range from 5 percent to 65 percent,
`depending on the disorder. Anxiety and depression often coexist — up to 80 percent of people
`who suffer from depression also experience symptoms of anxiety.7
`
`Depending on the anxiety disorder, drug therapy, psychotherapy, or some combination thereof
`can typically relieve the distress and dysfunction experienced by anxiety sufferers. Exhibit 2
`outlines the classes of drugs used to treat anxiety. Benzodiazepines such as Ativan, Xanax, and
`Valium are the most commonly used type of anti—anxiety drug. Drugs in this class promote
`mental and physical relaxation by reducing nerve activity in the brain. They generally begin to
`work quickly, sometimes within an hour. Benzodiazepines tend to be sedative (causing
`sleepiness, impaired coordination, and slowed reaction time), and long-term use can lead to drug
`dependence, so appropriate precautions should be taken when using these drugs. In 2002,
`Ativan’s US. sales were approximately $205 million, Xanax’s sales were about $155 million,
`and Valium’s sales were just over $110 million (including generic sales for all three drugs).
`Another type of anti—anxiety drug, Buspar, is used mainly to treat generalized anxiety disorder.
`Buspar does not cause sedation or lead to drug dependence, however, it can take two weeks or
`longer to start working. U.S. sales of Buspar in 2002 totaled $245 million (branded and generic).
`Antidepressants are also frequently used, either alone or in combination with benzodiazepines, to
`treat anxiety disorders.
`
`5 The .Merck Mamml Q/“M(ed1'cal I/i/iirmatirmz, 2”“? Home Ezlitmn, 2003.
`6 The INIGFC/{Ill/Itlflllcll ofjl/[edical Information, 2” Home Edition. 2003.
`7 Decision Resources, Inc. “Antidepressants and Anxiolyticsz Expanded Indications Fueling Market Growth." 2003.
`
`2
`
`Depomed Exhibit 2087, Page 3 of 12
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`Depomed Exhibit 2087, Page 3 of 12
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`

`
`Unmet Needs
`
`A broad range of antidepressant and anti-anxiety drugs with prov en mechanisms of action have
`been available for many years (eg, tricyclics, MAOIs, SSRIs, and benzodiazepines).
`Nonetheless, several areas of unmet need still remain.
`
`For treatment of depression, unmet needs representing the most commercial opportunity include
`long—term effectiveness, rapid onset of action, and improved side effect profile. Field surveys
`show that between 10 and 30 percent of patients who are prescribed an antidepressant do not
`complete treatment, either because ofa perceived lack of effectiveness (sometimes due to the
`delayed onset of currently available drugs) or because of side effects (which more than half of
`therapy—conipliant patients experience).8 In addition, studies show that 50 to 60 percent of
`patients who take antidepressants continue to experience residual symptoms after eight weeks of
`therapy; the presence of residual symptoms is a strong predictor of depression relapse? In order
`to provide significant benefits over existing therapies, a new antidepressant drug would need to
`be effective for more than 65 percent ofpatients, begin working within days instead of weeks,
`and have a favorable side effect profile (avoiding the sedation and overdose toxicity of tricyclics
`and the sexual dysfunction of SSRIS). Other attributes, such as once-daily administration and the
`ability to be used with other agents, would also be beneficial.
`
`With respect to anti-anxiety treatment, all benzodiazepines suffer from the same concerns,
`namely sedative side effects and the potential for addiction. An improvement over existing
`therapy would avoid these issues, without sacrificing speed of onset or efficacy.
`
`Products Currently in Development
`
`In the depression market, several pharmaceutical companies are attempting to improve onset of
`action and/or reduce common side effects either by developing new formulations or processes of
`synthesizing existing antidepressants, or by developing compounds that combine multiple
`established mechanisms. For example, Organon is in the latter stages of developing Variza, an
`extended—release formulation of the compound gepirone that targets specific serotonin receptors
`in the brain. Lilly has submitted an application to the FDA for Cymbalta, a selective reuptake
`inhibitor for both serotonin and norepinephrine similar to Effexor, and Sepracor is developing a
`serotonin, norepinephrine, and dopamine reuptake inhibitor called (R)-DDMS. Other companies
`are exploring entirely new mechanisms to treat depression and anxiety, such as GABAA receptor
`agonists, neuropeptides, and corticotropin-releasing factor antagonists.
`
`8 Decision Resources, Inc. (Ibid.)
`9 Decision Resources, Inc. “Psychiatric Disorders Study #1: Depression," 2002.
`
`Depomed Exhibit 2087, Page 4 of 12
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`Depomed Exhibit 2087, Page 4 of 12
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`

`
`Class / Drug
`Tricyclics and related drugs
`Elavil (amitriptyline)
`Asendin (amoxapine)
`Anafranil (clomipramine)
`Norpramin (desipramine)
`Sinequan (doxepin)
`Tofranil (imipramine)
`Ludiomil (maprotiline)
`Aventyl (nortriptyline)
`Vivactil (protriptyline)
`Sutrnontil (trimipramine)
`Selective serotonin reuptake
`inhibitors
`
`Celexa (citalopram)
`Prozac (fluoxetine)
`Luvox (fluvoxamine)
`Paxil (paroxetine)
`Zoloft (sertraline)
`
`Exhibit 1
`
`Drugs Used to Treat Depression
`
`Selected Side Effects
`
`Comments
`
`Sedation, weight gain,
`increased heart rate, decreased
`blood pressure, dry mouth,
`confusion, blurred vision,
`constipation, difficulty in
`starting to urinate, delayed
`orgasm, seizures (clomipramine
`and maprotiline)
`
`Side effects are usually
`more pronounced in older
`people. Serious, potentially
`life-threatening toxicity in
`overdosage.
`
`Sexual dysfunction (primarily,
`delayed orgasm but also loss of
`desire in some people), nausea,
`diarrhea, headache, weight loss
`(short—term), weight gain (long-
`term), withdrawal syndrome,
`forgetfulness, blunting of
`emotions, easy bruising
`
`Most commonly used class
`of antidepressants. Also
`effective for dysthymia,
`generalized anxiety
`disorder, obsessive-
`compulsive disorder, panic
`disorder, phobic disorder,
`posttraumatic stress
`disorder, premenstrual
`dysphoric disorder, and
`bulimia. Less serious risk of
`
`toxicity in overdosage.
`Requires dietary restrictions
`and precautions when using
`certain drugs.
`
`Generally not effective as
`antidepressants when used
`alone. Often used in
`combination with
`
`antidepressants.
`Most of the side effects can
`
`be prevented or minimized
`when low doses are used
`
`and when changes in
`dosages are made slowly.
`
`Monoamine oxidase
`inhibitors
`
`Nardil (phenelzine)
`Pamate (tranyl cypromine)
`
`Psychostimulants
`Dexedrine(dextroamphetamine)
`Ritalin (methylphenidate)
`
`Insomnia, weight gain, sexual
`dysfunction (loss of desire and
`delayed orgasm), pins—and—
`needles sensation, lowered
`blood pressure, severe high
`blood pressure
`Nervousness, tremor, insomnia,
`dry mouth
`
`Newer drugs
`Wellbutrin (bupropion)
`Remeron (mirtazapine)
`Serzone (nefazodone)
`Desyrel (trazodone)
`Effex or (Venl afaxine)
`
`Headache and rarely seizures
`(bupropion); dry mouth
`(Venlafaxine, mirtazapine);
`Weight gain (miitazapine); mild
`sedation and dizziness
`
`(nefazodone); prolonged
`sedation (trazodone)
`
`Source.’ I lie M'er(:/c,Marn1al oj'[\/;fe(licra/ Information, 2"“! Home Edition, 2003
`
`Depomed Exhibit 2087, Page 5 of 12
`
`Depomed Exhibit 2087, Page 5 of 12
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`

`
`Exhibit 2
`
`Drugs Used to Treat Anxiety Disorders
`
`Class / Drug
`Benzodiazepines
`Xanax (alprazolam)
`Librium (chlordiazepoxide)
`Tranxene (clorazepate)
`Valium (diazepam)
`Ativan (lorazepam)
`Serax (oxazepam)
`
`Uses
`Generalized
`anxiety disorder,
`panic disorder,
`phobic disorders
`
`Buspar (buspirone)
`
`Generalized
`anxiety disorder
`
`Comments
`Side Effects
`Sleepiness, impaired Most commonly used
`coordination,
`type of anti-anxiety
`slowed reaction
`drug. Promote mental
`time. May lead to
`and physical
`drug dependence;
`relaxation by reducing
`should not be used
`nerve activity in the
`by people who have
`brain. Begin to work
`an alcohol
`quickly, sometimes
`dependency
`within an hour.
`problem
`Dizziness, headache Does not cause
`sedation or interact
`with alcohol. Does
`
`not lead to drug
`dependence. Onset of
`anti—anXiety effects
`may take 2 weeks or
`longer.
`See Depression Table
`
`See Depression
`Table
`
`Antidepressants*
`[selective serotonin reuptake
`inhibitors, Effexor
`(venlafaxine), monoamine
`oxidase inhibitors, tricyclic
`antidepressants]
`
`Generalized
`anxiety disorder,
`panic disorder,
`phobic disorders,
`obsessive-
`compulsive
`disorder,
`posttraumatic
`stress disorder
`
`* Not all of the antidepressants listed work for all of the uses that are listed.
`
`Source: The Merck A/Ianual ofMedical Informafimi, 2"‘! Home Edition, 2003
`
`Depomed Exhibit 2087, Page 6 of 12
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`Depomed Exhibit 2087, Page 6 of 12
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`

`
`PROFILE OF DEPRESSION/ANXIETY DRUG CANDIDATE ABC 551
`
`Existing Research
`
`The compound that Melissa is currently evaluating, ABC 551, is a proprietary agent within the
`corticotropin-releasing factor (CRF) antagonist class. Preclinical data from the company’s
`research laboratories suggest that this mechanism of action may provide a novel approach to the
`treatment of psychiatric disorders including generalized anxiety and depression. CRF is a
`hormone that stimulates the secretion of cortisol in response to stress.
`In preclinical studies,
`ABC 551 demonstrated the ability to block stress responses, by decreasing sympathetic nervous
`system activity including heart rate and blood pressure. Increased sympathetic activity is a major
`component of some anxiety states such as panic attacks. Additional research suggests that ABC
`551 may also be effective in treating depression, and that by lowering CRF levels ABC 551 may
`reduce the likelihood of depression relapse.
`
`It is hoped that ABC 551 will fulfill the promise of providing an effective treatment for both
`depression and anxiety disorders without producing the physiological dependence of
`benzodiazepines or the unwanted side effects of SSRIS. Further studies will determine whether
`ABC 55] has a more rapid onset of action than existing antidepressants. If ABC 551 is shown to
`have these benefits, it is possible that this drug may someday replace or supplement currently
`available therapies. As one of the early entrants in the novel class of CRF antagonists, ABC 551
`has the potential to capture a sizable share of the depression and anxiety markets.
`
`Estimating the Value of ABC 551
`
`Whether or not to continue development of ABC 551 is a key decision, given the significant
`expenses and risks associated with drug development. Last year, the company spent $3 billion
`on research and development, comprised of $900 million for discovery research and preclinical
`development, and $2.1 billion for clinical trials. Of the $900 million spent on preclinical R&D,
`$800 million represented chemical compounds that failed before reaching the clinical
`development stage, likewise, of the $2.1 billion spent on clinical testing, $1.2 billion was applied
`to drugs that ultimately will never reach the market. Even if a drug is approved, only three out of
`ten new drugs that reach the market earn enough to cover average R&D costs. 10
`
`The financial model that Melissa is using to evaluate ABC 551 is contained in an Excel file
`called “WhartonCaseStudy.xls”. Three types of data are required to estimate ABC 551 ’s
`expected net present value: the probability that the drug will advance from one development
`stage to the next, the R&D costs associated with each development stage, and the commercial
`value of the drug if it is approved by regulatory agencies including the Food and Drug
`Administration (FDA).
`
`Probability of Technical Success
`
`Like most drug candidates, there is a great deal of uncertainty as to whether ABC 551 will
`ultimately obtain regulatory approval. ABC 551 has just completed four years of preclinical
`
`10 Grabowski et a1., “Returns on Research and Development for 19905 New Drug Introductions,”
`P/rarmacoeconomics, 2002.
`
`Depomed Exhibit 2087, Page 7 of 12
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`Depomed Exhibit 2087, Page 7 of 12
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`

`
`testing. Ifl\/lelissa makes a compelling case to continue developing the drug, the company will
`begin Phase Itrials at the beginning of 2004. If results continue to look favorable, the drug will
`move into Phase 11 and Phase 111 trials; then the company will submit an application to the FDA
`and other regulatory agencies (in relevant countries) to be considered for approval. Exhibit 3
`describes the various stages of the drug development process.
`
`Based on past experience and estimates from the Research Department, ABC 551 has a 71
`percent probability of advancing from Phase Ito Phase II, a 44 percent chance of moving from
`Phase 11 to Phase III, a 76 percent probability of completing Phase III, and a 90 percent
`probability of receiving marketing approval following submission to regulatory agencies. Based
`on these phase transition probabilities, the likelihood that ABC 551 will enter each development
`phase can be calculated, as shown in the second row of Table A below. For example. since ABC
`551 has already successfully completed preclinical testing, the probability of entering Phase I
`(and incurring Phase 1 development costs) is 100 percent (assuming the company decides to
`continue development of ABC 551). The probability that ABC 551 will enter Phase II equals the
`probability of entering Phase 1 times the probability of advancing from Phase 1 to Phase 11: 100%
`x 71% = 71%. Likewise, the probability that ABC 551 will enter Phase I11 equals the probability
`of entering Phase 11 times the probability of advancing from Phase II to Phase III: 71% x 44.2%
`= 31.4%. Carrying these calculations a couple steps fuither shows there is a 21.5 percent
`probability that ABC 551 will successfiilly complete Phase III and receive approval for
`marketing. A drug’s chances of reaching the market improve as the drug proceeds through each
`stage of development: before ABC 551 had passed preclinical screening, its estimated
`probability of success was less than 21.5 percent, and if ABC 551 successfully completes Phase 1
`its probability of reaching the market will increase above 21.5 percent. The phase transition
`probabilities can be used to calculate ABC 55l’s probability of technical success at different
`points in time.
`
`Table A
`
`iiiiiiiiiii
`.
`
`71.0%
`
`100.0%
`
`44.2%
`
`71.0%
`
`76.1%
`
`31.4%
`
`Review
`90.0%
`
`23.9%
`
`ization
`NA
`
`21.5%
`
`Phase T.r.a“S‘“°“
`Prob ability
`Pmba.b””Y of
`Entering Phase
`
`R&D Expenses
`
`By the end of 2003, ABC 551 will have completed preclinical testing. Discovery research and
`preclinical development expenses for ABC 551 were about $66.8 million; however, these
`expenditures will not factor into Melissa’s forward—looking analysis because they occurred in the
`past and are irreversible — they cannot be affected by the decision to continue or discontinue
`development of ABC 551, and so they are not relevant to the current analysis. 11 Likewise,
`Melissa will not consider the cost of other, failed chemical compounds when assessing the
`current value of ABC 551. These other research projects will succeed or fail regardless of
`whether the company continues to develop ABC 551; thus, these costs are not relevant to the
`development decision for ABC 551, which should be evaluated solely on its own merits.
`
`11 Brcalcy and Myers, Prirzoiples of Corpo/‘are Fma/7ce, 2000.
`
`Depomed Exhibit 2087, Page 8 of 12
`
`Depomed Exhibit 2087, Page 8 of 12
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`

`
`The Research Department estimates that clinical development for ABC 551 will take
`approximately eight years (from 2004 to 20l l) and will cost about $180 million (before
`discounting by the cost of capital, to account for the time value of money), the R&D expenses
`associated with each development stage are reported in Table B.
`
`Table B
`
`Reg. Review
`Phase 111
`Phase II
`Phase I
` Pre-tax R&D Expenses
`$32.4 million
`$91.4 million
`$36.1 million
`$20.4 million
`
`As noted above, these R&D expenses do not include discovery research and preclinical
`development, the cost of failed research projects, or the cost of capital. Research has shown that
`when these additional factors are included, it costs approximately $802 million (pre-tax) on
`average to bring a drug successfully to market (as of the year 2000). 12 According to recent
`research, drugs that treat diseases of the central nervous system (such as depression and anxiety)
`tend tg cost even more to develop ~ about l3 percent, or S 100 million, more than the average
`drug.
`
`Commercial Value
`
`The third required data element is the commercial value of ABC 55] conditional on receiving
`regulatory approval. If research studies find that ABC 551 can provide superior efficacy, faster
`onset of action, and/or less severe side effects than currently available treatments, ABC 551
`could have significant commercial potential. The Marketing, Manufacturing, and Finance
`Departments have forecasted the revenues and various costs that ABC 551 will incur, assuming
`it is approved for the treatment of depression and anxiety disorders in the US and Canada in
`2012, and in Europe in 2013. In reality, ABC 551 would likely be sold in other countries as
`well; however, in the antidepressant and anti—anxiety markets the vast majority of revenues
`(about 89 percent in 2002) come from the US, Canada, and the
`so for simplicity Melissa has
`only included these three regions in her financial model.”
`
`Len, the Director of Marketing, has provided Melissa with sales forecasts for ABC 55 l, broken
`out by indication (i.e., depression and anxiety) and by geographic region (i.e., U Canada, and
`Europe). To arrive at these forecasts, the Marketing Department conducted extensive market
`research on disease prevalence, treatment rates, treatment paradigms, and competitive products
`(current and anticipated). The Depression and Anxiety worksheets contain the assumptions
`underlying the estimates of the drug’s revenues for the two indications. For example, for the
`depression market, the forecasts use the prevalence of depression in each geographic market as a
`starting point. The company assumes that 25 percent of individuals suffering from depression
`will be diagnosed and treated with an antidepressant drug, and that ABC 551 will achieve a l0
`percent market share five years after being approved.
`It is assumed that patients using the drug
`will take it for an average of 290 days per year and that the company will receive $238 per daily
`
`13 Dil\/Iasi, Hansen, Grabowski, “The price of innovation: new estimates of drug development. costs," Journal of
`Hea/t/'1 Ec.-mirmzics, 2003.
`
`13 Tufts Centerfor the Study of Drug Development, News Release, April 29, 2004.
`14 Japan, which is generally considered a major pharmaceutical market, represents only 3.5 percent of 2002
`worldwide antidepressant and anti—anxicty drug revenues (Source: IMS Health).
`
`Depomed Exhibit 2087, Page 9 of 12
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`Depomed Exhibit 2087, Page 9 of 12
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`

`
`dose in the U.S. market, which is the average manufacturer°s net price (i.e., net of discounts) for
`branded drugs currently being used to treat depression. Prices per dose are expected to be lower
`in Canada ($1.52 per daily dose) and the European Union ($l .55 per daily dose). A similar
`approach yields ABC 55 l’s estimated revenue for the treatment of anxiety disorders. This
`revenue information is summarized in the Sales worksheet and then reported in rows 9~ E
`'2 of the
`SCF worksheet. The drugs patent is assumed to expire in rr1id—2.025, at which time generic
`drugs are expected to be available and fully utilized.”
`
`Production and marketing costs are also detailed in the SCF worksheet. These
`commercialization expenses, along with R&D expenses and other cash outlays (such as capital
`expenditures and changes in working capital), are deducted from revenues to arrive at ABC
`55 ‘I ’s total cash flows for each year.
`
`TfMelissa’s company decides to continue development of ABC 55l, Phase I research will be
`incurred with certainty in 2004-2005. However, the R&D expenses forecasted for 2006 and
`beyond will only be incurred if ABC 551 successfully advances to each successive development
`stage.
`In the same way, sales revenues and commercializati on expenses will only be realized if
`the drug makes it to market. Thus, ABC 551’s annual cash flows are adjusted for the probability
`of realizing these cash flows when calculating the expected net present value of ABC 551.
`Specifically, ABC 55 l’s total cash flows for each year are multiplied by the probability that
`ABC 551 will still be under development / on the market in that year, to arrive at ABC 55 l ’s
`expected annual cash flows. For example, Phase I cash flows are multiplied by lOO percent and
`Phase 11 cash flows are multiplied by 71 percent; post-launch cash flows are multiplied by 21.5
`percent.
`
`Estimating the Expected Net Present Value of ABC 551
`
`The final step in estimating the current expected net present value of ABC 551 is to discount the
`expected cash flows by the company’s cost of capital. The cost of capital represents the rate of
`return that investors expect to earn on their investment in the company. It is the expected return
`that investors could have earned by investing in equally risky securities (such as stocks) rather
`than investing in the company. Financial analysts have estimated the company’s cost of capital
`to be l2 percent, based on a weighted average of the company’s borrowing rate and expected
`returns on the company’s stock.
`
`Cell £343 of the SCF worksheet computes ABC 55l ’s expected net present value (NPV) as of the
`beginning of Phase L16 A positive NPV indicates that the expected rate of return exceeds the
`cost of capital (i.e., l2 percent), which means the project is projected to be a profitable
`opportunity for the company (and the company’s shareholders).
`
`15 ABC 55l’s patent was filed at the beginning of 2000. The term of the patent is 20 years; in addition, the company
`expects the patent to be eligible for a 55-year extension.
`(For more details on patent terms and ex1ensions, see
`Module D.)
`1“ Cell H52 of the SCF worksheet calculates ABC 551’s expected NPV at the start of Phase III.
`
`Depomed Exhibit 2087, Page 10 of 12
`
`Depomed Exhibit 2087, Page 10 of 12
`
`

`
`[l)on’t use any of the “drop down” boxes that may appear in the Excel spreadsheet; they
`are not programmed properly]
`
`Discussion Questions
`
`l. Determine the profile of financial outcomes (in dollars) for ABC 55l that might actually be
`achieved. For example, one outcome is that the drug may fail in Phase 1. Other possibilities are
`that the drug fails in phase 2, fails in phase 3, is rejected by the FDA, or reaches the market. How
`much will the company lose or make in these 5 situations (you might want to assume that if the
`drug fails in a phase, all the R&D for that phase is spent)? What is the probability that the
`company will actually make money on this drug? What is the probability the company will lose a
`large amount on the drug? Does this information help you make a decision regarding whether or
`not to develop ABC 551? If so, how does it help‘?
`
`2. Calculate the expected net present value of the drug assuming that it “survives” phase l and
`reaches phase 2 (2006) and all of the current assumptions about the market remain the same.
`Perform the same calculation to determine the expected value of the drug if it is about to start
`phase 3 (2008), and if the FDA approves it (2012). Why is the value increasing as the drug
`progresses? For what type of company would this analysis be very important, and for what type
`of company might it be less important?
`
`L.)
`
`Assume that a large pharmaceutical company proposes a strategic alliance with the following
`terms: Melissa’s company would continue to develop the drug in Phase 1 and would be
`responsible for paying Phase 1 R&D costs. If the drug advances to Phase 2, the larger company
`would have responsibility for developing the drug in Phase 2 and Phase 3, getting it approved,
`manufacturing it, and marketing it. The larger company would pick up all of the costs associated
`with Phase 2 and beyond. Melissa’s company would receive a $6 million upfront payment
`(presumably to be used to defray some of the Phase l R&D costs), an $8 million milestone
`payment if the drug advances to Phase 2 (this would be received at the end of 2005 if Phase 1 is
`successful), and 5% royalty payments on gross sales of the drug. Your company would be taxed
`on these payments (35% tax rate). VVould you accept this proposed alliance ?
`
`4. How does this proposed strategic alliance (in question #3) alter the risk of the project‘? That is,
`how does the deal affect the profile of possible financial outcomes you analyzed in question 1?
`
`5. A CRO claims to be able to shave a year off of the amount of time it takes for a drug to reach the
`market, so that it would be approved in 2011 instead of 2012 if all goes well. How much should
`your company be willing to pay for this result for ABC 551? Assume that the CRO shortens
`phase 3 so that it lasts only 1 year instead of 2, but the R&D costs for phase 3 remain the same.
`
`6. Should you continue to develop ABC 551 or cease developing it?
`
`10
`
`Depomed Exhibit 2087, Page 11 of 12
`
`Depomed Exhibit 2087, Page 11 of 12
`
`

`
`Exhibit 3
`
`new Drug I}evel0pment Process
`
`Dist m'e:“y£P1‘ecliuicai Testing
`Sfmthesis ~c>f-cu1;1p0un«ds
`
`Glinicai
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`Phage I
`
`20-80 heahhy v<:Ȥm1tee1'3
`Determine safetg-' anti éosage.
`Metaboliu: effevcta. abésorptahn. trmicity
`
`Phase II
`
`300-360 patient xroklureers
`Dbtain esvideme m1 safeg’.
`P‘2‘eiinJi115e1”§r tiara can efficacj;
`
`Lzftnoratwy and animal tesiiilg
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`Testing
`
`Apgzemval
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`Phase III
`
`LG§}f}—5_.~f‘tC}0 patiem v0E1u}t»é~.e:'3
`Firm}y esfiablish efficacy.
`N§€éI1iE01‘.°EdVEITS€ mactians ta imgg-tem1
`
`FDA Review?
`
`{D
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`be
`
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`‘1’e:m2
`
`10
`
`£2
`
`14
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`HIRMA, P}zm"mnc“€zamin? Ii'r(¢’u.sf}j1-' Profiie 3:903
`Iiimasié, Hamen. Grabmwskzi. "The price of iI1n0va£m11:: new estilnates cnfdrsxg developxxlaxii testis," J9z»:r‘3m.5 qffiemiii: Em
`
`II
`
`Depomed Exhibit 2087, Page 12 of 12
`
`Depomed Exhibit 2087, Page 12 of 12