Two months earlier, Kappa Labs had approached Merck with a proposal that Merck purchase the rights to KL-798 for an upfront payment of $30 million and royalty payments over the first 10 years of the product's lifetime. Because KL-798 was in Phase I trials and FDA approval, if granted, was seven to nine years in the future, the royalty payments would essentially span the remaining patent-protected life4 of any emergent product.

As a result of these market conditions, the successful commercialization of KL-798 would be enormously valuable to Merck. If the product could be marketed for the treatment of both obesity and cholesterol reduction, the project team estimated that the drug would have a market value of $510 million. (This and all subsequent market values represented the present value of the resultant cash flows, including royalty payments to Kappa Labs but excluding the costs of the clinical testing needed to gain approval and the initial $30 million licensing payment.) This $510 million market value assumed that physicians could prescribe this one drug for patients with both maladies as well as for patients with either malady. If the approval process limited the drug to just one malady, the present values would be $430 million if the drug were approved for obesity and $50 million if approved for cholesterol reduction.

The Phase I trial of KL-798 had been under way for nearly six months. To date, there had been no severe adverse reactions from the test population of 65 healthy volunteers. Based on its review of Kappa Labs' research notes and its own limited experience, the project team believed that KL-798 had a 60% chance of successfully completing Phase I. Were Merck to buy the rights to KL-798, the cost to the company of completing Phase I would be $5 millionhalf of the total cost. (This and all subsequent costs of approval are expressed as present values.)

In KL-798's Phase II trial, Merck would organize a group of several hundred patientvolunteers to determine the compound's efficacy in the treatment of obesity and high cholesterol as well as to document any side effects. The final determination of efficacy would rest on the degree of statistical significance of the difference in effect on those patients with the condition (obesity and high cholesterol) who had been given KL-798 versus those who had received a placebo. The project team estimated that there was a 10% chance that KL-798 would show indications of treating obesity only, a 10% chance of treating high cholesterol only, and a 30% chance of effectively treating both conditions at the same time. Phase II would require two years to complete would cost $40 million. If KL-798 succeeded in Phase II trials, the next step in the approval process would require that it be administered to several thousand patient-volunteers over several years. The test population, the cost, and the success of this third phase of testingand, ultimately, FDA approvalwould depend on the results of Phase II. If the Phase II results indicated that KL-798 was effective in combating obesity only, the Phase III trial, leading to a product that treated obesity only, would cost $50 million and would have a 75% chance of ultimately receiving FDA approval. If the Phase II trial indicated that it was effective in treating high cholesterol only, the Phase III trial for the commercialization of a cholesterol-treatment product would also cost $50 million and would have a 70% chance of achieving final approval. If, however, the Phase II results indicated efficacy for both maladies, the required Phase III trial for the introduction of a single product that treated both obesity and high cholesterol would be more extensive and would be specifically tailored to the introduction of that single drug as treatment for both maladies. Because of the specialized population required for this trial and the additional complexity of testing for both multiple and joint indications, the cost would be $140 million, substantially more than the other two tests combined. The trial could lead to approval for the treatment of both maladies (60% chance), approval for the treatment of obesity only (15%), or approval for the treatment of high cholesterol only (10%).

Question 1- Build a decision diagram to evaluate the decision facing Pat Harlow. What would you recommend? (Be sure to state all your assumptions and show all your analysis.) 2- To which assumptions (other than Mr. Merck's) is your analysis most sensitive, and what might be done to manage their related risks? Note that we are looking for analysis and insights, not laundry lists. (your analysis may include risk profiles and sensitivity analysis for phase costs, probability of success, and Market values). 3- Foresight Consulting has offered to conduct research that will enable it to predict KL798's outcome in both phase I and phase II trials. How much would this information be worth to Merck if Foresight's predictions were always correct (EVPI)? This is a risk neutral (EMV) analysis exercise.