Question

New Dawn pharma is considering the acquisition of a small biotech company—Sunset Pharmaceuticals. Sunset is developing a new drug that, if successful, would revolutionize the treatment of pancreatic and/or liver cancer. Sunset is about to start Phase I of the clinical testing for the new drug. New Dawn estimates that if they acquired Sunset the costs associated with Phase I testing would be around $60 million. They believe the probability of successful Phase I testing is 30%. Phase 2 testing for the pancreatic cancer and/or liver cancer indication would cost $170 million. The probability that Phase 2 testing will show effectiveness for pancreatic cancer is 25%. The probability that Phase II will show clinical efficacy for liver cancer only is 45%. Phase 3 testing for the pancreatic cancer indication will cost $300 million. The probability that Phase 3 testing for pancreatic cancer will be successful is 40%, and the cost of launching the drug for the pancreatic indication only will be $250 million. New Dawn estimates that future cash flows from a successful pancreatic cancer indication will be in the vicinity of $10 billion. Phase 3 testing for the liver cancer indication only will cost $350 million. The probability that Phase 3 testing will show effectiveness for liver cancer is 70%, and the cost of launching the drug for the liver indication only will be $200 million. Estimates for future cash flows from a successful liver cancer launch are in the vicinity of $20 billion. (All cash flows are expressed in after-tax present values discounted to time zero, including capital expenditure.)

B. Sunset has about $70 million in fixed assets and $500 million in debt/outstanding obligations to investors that will have to be paid off before the merger can proceed. Sunset is being sued by an academic partner for patent infringement on their new drug line. If the lawsuit is settled, they will have to pay around $200 million to the University. New Dawn’s lawyers are saying that this is likely to happen with probability 95%. However, if the University is not willing to settle and they go to court, there is a 30% probability that the University will receive 30% of any and all proceeds from the drug’s sales and will not share any of the costs of development. Based on this information, what is the value of Sunset as a stand-alone company?

Answer 1

Decision Tree Analysis

Question 1: NPV

We get the NPV of the project by adding the expected cash flows from the project and the subtracting the cost incurred in the project. The expected cash flows = Cash flows expected from successful launch of the liver cancer drug + cash flows expected from successful launch of the pancreatic cancer drug.

Liver drug= cash flows resulting from successful launch + cash flows expected in unsuccessful launch

            =30% * 45% *70% * $20 Billion + 30% * 45% * 30% * $0

Total cash flows expected from successful testing and launch of the liver cancer drug

                        =$1.08 Billion + $0 = $1.08 Billion

Pancreatic drug= cash flows resulting from successful test and launch + cash flows from unsuccessful launch

                        =30% * 25% * 40% * $10 Billion + 30% * 25% * 60% * $0

Total cash flows = $0.525 Billion + $0 = $0.525 Billion

Total cash flows from the new drug project= $0.525 Billion +$1.08 Billion = $1.605 Billion

Costs: Joint costs

                        Phase 1             $60 Million

                        Phase 2             $170 Million

Specific Costs    Liver drug

                        Test Costs         $350 Million

                        Launch costs      $200 Million

                        Pancreatic drug

                        Test costs          $300 Million

                        Launch costs      $250 Million

Total Costs = $1.330 Billion

NPV of the project = Cash flows – costs

                        =$1.605 Billion - $1.330 Billion = 0.275 Billion i.e. $275 Million

New Dawn should pursue this venture because it has a positive NPV.

Question 2. Valuation of Sunset

Assets                            $70 Million

Debt                              $500 Million

Patent Obligation           $200 Million with 95% probability; or 5% chance they will pay 30% of total future cash flows. This has probability 30%

Standalone value of Sunset = Assets – Obligations

Patent obligation = Chance of paying $200 Million + Chance of paying the 30% of future cash flows

            = (95% * $200 Million) + (5% * 30% * 30% * $30 Billion) = $325 Million

Value =$70 Million - $325 Million - $500 Million = $755 Million.