How much will Grace end up with including the $9 billion cash payment under the base case scenario?

Drug Revolution/Grace Pharmaceuticals Joint Venture Background Information: In early 2018, Kieran Gregory, President and CEO of Drug Revolution, met with members of a joint-venture negotiating team to develop proposed terms of a joint venture agreement. The venture would combine capabilities of Drug Revolution, Inc. and Grace Pharmaceuticals, Inc. Drug Revolution has announced that it is interested in acquiring a 70% share to Zipit a Liquid Filled Capsules from Grace Pharmaceuticals, Inc. Zipit is specifically indicated for the relief of mild to moderate acute pain in adults (18 years of age or older). Zipit is supplied as a 25mg liquid filled capsule for oral administration. The approved dose is 25 mg four times a day. The product uses proprietary delivery technology to deliver a finely dispersed, rapidly absorbed formulation of the drug. The mechanism of action of Zipit, like that of other NSAIDs, is not completely understood but may involve inhibition of the cyclooxygenase (COX-1 and COX-2) pathways. Zipit’s mechanism may also be related to prostaglandin synthetase inhibition. Grace Pharmaceuticals introduced Zipit to the US market the same year it was approved by the FDA. While Grace Pharmaceuticals has done a decent job of marketing Zipit, the company does not have much in the way of extra funds or detailed distribution channels so the sales could potentially be much higher than what Grace has been able to achieve at this point. Drug Revolution is looking to acquire a 70% share in the product in return for an upfront payment to Grace of $9 billion in cash. “We are pleased to expand our portfolio of pain products with the addition of Zipit to our sales force of 164 reps and 78 flex reps that today are detailing Drug Revolution’s small molecule pain medications,” said Kieran Gregory of Drug Revolution. “Zipit is an NSAID that we believe is differentiated in the pain space, allowing rapid absorption of the lowest available oral dose of the drug. Zipit will have an almost immediate positive impact on Drug Revolution’s financials. We believe we will have the runway to achieve significant returns for our shareholders from this joint venture, with the Orange Book listed patent for Zipit expiring in 2033. We plan to utilize our sales force to promote Zipit to pain specialists, neurologists, and high prescribing PCPs, including those we currently detail for our small molecule drug in addition to current prescribers of Zipit.” Grace Pharmaceuticals had been looking for a partner that would contribute cash and marketing expertise in exchange for a share of profits in a joint venture. The joint venture with Grace was attractive to Drug Revolution for several reasons as noted above. Kieran Gregory was eager to conclude a deal with Grace’s board and launch the venture with Grace. Important questions, however, had to be addressed before consummating an agreement. • What was the likely NPV of the joint venture? Gregory wanted the joint venture to be a 70/30 balance of interests between Drug Revolution and Grace Pharmaceuticals. Initial discussions had focused on Drug Revolution paying a lump-sum payment of $9 billion for their 70 percent interest in the venture. Rather than concentrate efforts on the next big hit Drug Revolution had decided to manage its R&D like a portfolio by outsourcing innovations through partnerships. Drug Revolution’s strategy was to supplement its internal R&D with strategic alliances with external companies in order to access high-quality products in late-stage development or recent approval. Because of encouraging results of Grace Pharmaceutical’s limited launch of the drug, management believed that Zipit would be launched full force in the U.S. immediately and in Europe starting 2019. The possible joint venture between Drug Revolution and Grace Pharmaceuticals would concern only the U.S. and European markets. Depending on market conditions (e.g. competition, health-care policies, patents and market need), the remaining life cycle of Zipit drug is estimated at 18 years including year 2018. Market Characteristics The target markets for Grace Pharmaceuticals were patients with mild to moderate arthritis who would be treatable with an NSAID category drug. Drug Revolution’s projections show that there are approximately 250 million current prescriptions filled each year for these types of ailments. Drug Revolution estimates a compounded annual growth rate of 3 percent over the last 10 years, driven by multiple factors including the aging of the population and increases in the incidence of chronic illness. They feel comfortable that the 3% growth rate will continue in the US for the length of the project. Europe has the same number of prescriptions for forecasting purposes, with the prescriptions growing at approximately 2% annually. These growth rates were expected to continue into the near future. Forecast of Income Statements Since many factors vary predictably with the volume of sales, the primary variable forecasted was Zipit revenues. People with aspirin-sensitive asthma or allergic reactions due to aspirin or other NSAIDs should not take Zipit. Prescription Zipit should be used exactly as prescribed at the lowest possible dose for the shortest time needed. The team projects that after being fully rolled out in the U.S. market during 2018 the drug is expected to enter the European market the following year. It is estimated that 60 percent of the U.S. market would be eligible for the drug, while this ratio might be lower (50 percent) for the European market. Many factors are expected to influence revenues. • Peak penetration rate in the market: Based on different marketing analyses and analysts’ reports, the best guess of market penetration for the drug are seen in below: Market 2018 2019 2020 2021 2022 2023 2024 2025 2026 Penetration 7.00% 15.00% 20.00% 35.00% 35.00% 35.00% 35.00% 35.00% 35.00% Market 2027 2028 2029 2030 2031 2032 2033 2034 2035 Penetration 35.00% 35.00% 35.00% 35.00% 35.00% 30.00% 25.00% 20.00% 20.00% • Compliance: Not all patients who use the drug will do so faithfully, even with a doctor strongly recommending its use. The team believes that the most likely compliance rate would be an average of 87 percent. (i.e. The number of actual prescriptions filled in any given year would be equal to (eligible prescriptions)*(percent penetration)*(.87)) • Price per prescription: The annual price of the drug per patient would depend on many things, including how many capsules the patient used and competitive pressures on the price that could be charged for the capsules. The joint-venture team had worked up an estimated figure of $150 as the average cost per prescription filled. The $150 figure is to be used for both the US and European sales. Variable Costs: Although the variable costs of the drug are hard to pinpoint, they are not the most critical variable in the success of the drug. The team members decided to use the industry average of 40% of annual sales revenues to forecast variable costs each year. Fixed Costs: Fixed Costs which would include sales, marketing, and general and administrative expenses are projected as follows (Note: the values are in thousands of dollars): Fixed 2018 2019 2020 2021 2022 2023 2024 2025 2026 Expenses 4,800 6,950 10,500 12,500 15,000 16,250 17,500 18,500 19,500 Fixed 2027 2028 2029 2030 2031 2032 2033 2034 2035 Expenses 20,500 21,500 23,000 22,000 22,000 22,000 22,000 22,000 22,000 Net Working Capital: Net working capital for the joint venture is estimated to comprise a 45-day collection period for receivables, a 90-day period for Zipit inventory, and a 45 day period for payables. Below are the overall changes in net working capital for each year. (Note: the values are in thousands of dollars): Change 2018 2019 2020 2021 2022 2023 2024 2025 2026 In NWC (1,000) (10,000) (13,220) (23,580) (57,770) (84,970) (78,870) (39,930) (21,780) Change 2027 2028 2029 2030 2031 2032 2033 2034 2035 In NWC (23,400) (20,250) (16,070) (17,920) (16,970) (12,420) (3,150) (2,150) (1,000) Capital Expenses and Depreciation Expenses: The team forecasts capital spending of $4.97 billion split over the first three years of the venture (i.e. outflows of $1.75 billion in 2018, $2.42 billion in 2019, and $800 million in 2020). The yearly depreciation used is show below (Note: the values are in thousands of dollars): 2018 2019 2020 2021 2022 2023 2024 2025 2026 Depreciation 105,000 105,000 297,500 297,500 297,500 297,500 297,500 297,500 297,500 2027 2028 2029 2030 2031 2032 2033 2034 2035 Depreciation 297,500 297,500 297,500 297,500 297,500 297,500 297,500 297,500 297,500 Cost of Capital: The last decision that had to be made by the Drug Revolution’s joint-venture team is choosing a required rate of return for discounting the cash flows for the joint venture. The company’s debt currently has a yield to maturity of 10%. The tax rate appropriate for the joint-venture was 30%. Debt constitutes 30% of the cost of capital. Preferred stock usually makes up 10% of all capital and the average current cost of preferred is 14%. Common stock makes up 60% of all capital sources and has an average cost of 16.5%. While the firm expects the drug to be a success they recognize that most new drug ventures come with additional risks and thus have designated a risk premium of 4.6% in addition to the calculated weighted average cost of capital. Capital Budgeting Analysis: 1. Set up the Net Income Statement for the joint venture. 2. Calculate the WACC 3. Calculate the Joint-Venture’s annual cash flows from the project. 4. Calculate the Net Present Value of the enterprise value for the overall project prior to the allocated split in revenues and the 9 billion dollar payment? 5. Assuming Drug Revolution will negotiate a 70% share in the venture and that they pay a lump sum payment of $9 billion in 2018, what is the resulting NPV to Drug Revolution under the base case scenario? 6. How much will Grace end up with including the $9 billion cash payment under the base case scenario? 7. Should Drug Revolution enter into this joint venture using only the base case scenario? Explain your answer. 8. As a way of understanding how sensitive their numbers are to sales forecasts Drug Revolution has decided to analyze the NPV using a sensitivity analysis based off the Total Revenue for all sources of income line on the proforma statement. Drug Revolution will use a +/- 20% of Total Global Sales Revenue to estimate how sensitive their NPV results are to changes in total global revenue. Determine what the NPV for each of these scenarios would be. 9. Assume the base case is assigned a probability of occurrence of 60%. Also assume that the best and worst case scenarios have probabilities of 10% and 30% respectively. Given above adjustments what would the expected NPV for Drug Revolution be? Should this analysis adjust your recommendations of an accept/reject decision for Drug Revolution? 10. What are some of the other methods that are used to evaluate investment projects and compare them to NPV? No specific calculations here, just a discussion. Explain some of the potential drawbacks in this specific case with using the other investment evaluation methods. 11. Would it be possible to calculate the IRR of this joint-venture? You do not have to do the calculation, but discuss if it is possible to do and if there would be a problem calculating the IRR in this specific problem. Appendix 1: Sample First Year Proforma Income Statement Forecasted Income Statement ($000’s) Joint-Venture 2016 Market Penetration U.S. Market prescriptions filled Eligibility Total Eligible U.S. prescriptions European Market prescriptions filled Eligibility Total Eligible European Prescriptions Total Customer Base Both Markets Total Revenues($000) Variable Costs (000’s) Fixed Expenses (000’s) Depreciation (000’s) EBIT (000’s) Tax (@30%)* Net Income (000’s) * Note: Assume there is no tax effect if EBIT is negative. Appendix 2: Sample Free Cash Flow Calculation Drug Revolution/Grace Pharm Joint-Venture Forecast of Cash Flows (000’s) 2016 Net Income Add back depreciation Net Operating Cash Flow Net Working Capital Change in NWC Recovery of NWC Total Change in NWC Capital Spending Initial Outlay Free Cash Flow:

Drug Revolution/Grace Pharmaceuticals Joint Venture

Background Information:

In early 2018, Kieran Gregory, President and CEO of Drug Revolution, met with members of a joint-venture negotiating team to develop proposed terms of a joint venture agreement. The venture would combine capabilities of Drug Revolution, Inc. and Grace Pharmaceuticals, Inc. Drug Revolution has announced that it is interested in acquiring a 70% share to Zipit a Liquid Filled Capsules from Grace Pharmaceuticals, Inc. Zipit is specifically indicated for the relief of mild to moderate acute pain in adults (18 years of age or older). Zipit is supplied as a 25mg liquid filled capsule for oral administration. The approved dose is 25 mg four times a day. The product uses proprietary delivery technology to deliver a finely dispersed, rapidly absorbed formulation of the drug. The mechanism of action of Zipit, like that of other NSAIDs, is not completely understood but may involve inhibition of the cyclooxygenase (COX-1 and COX-2) pathways. Zipit’s mechanism may also be related to prostaglandin synthetase inhibition.

Grace Pharmaceuticals introduced Zipit to the US market the same year it was approved by the FDA. While Grace Pharmaceuticals has done a decent job of marketing Zipit, the company does not have much in the way of extra funds or detailed distribution channels so the sales could potentially be much higher than what Grace has been able to achieve at this point. Drug Revolution is looking to acquire a 70% share in the product in return for an upfront payment to Grace of $9 billion in cash.

“We are pleased to expand our portfolio of pain products with the addition of Zipit to our sales force of 164 reps and 78 flex reps that today are detailing Drug Revolution’s small molecule pain medications,” said Kieran Gregory of Drug Revolution. “Zipit is an NSAID that we believe is differentiated in the pain space, allowing rapid absorption of the lowest available oral dose of the drug. Zipit will have an almost immediate positive impact on Drug Revolution’s financials. We believe we will have the runway to achieve significant returns for our shareholders from this joint venture, with the Orange Book listed patent for Zipit expiring in 2033. We plan to utilize our sales force to promote Zipit to pain specialists, neurologists, and high prescribing PCPs, including those we currently detail for our small molecule drug in addition to current prescribers of Zipit.”

Grace Pharmaceuticals had been looking for a partner that would contribute cash and marketing expertise in exchange for a share of profits in a joint venture.

The joint venture with Grace was attractive to Drug Revolution for several reasons as noted above. Kieran Gregory was eager to conclude a deal with Grace’s board and launch the venture with Grace. Important questions, however, had to be addressed before consummating an agreement.

What was the likely NPV of the joint venture? Gregory wanted the joint venture to be a 70/30 balance of interests between Drug Revolution and Grace Pharmaceuticals. Initial discussions had focused on Drug Revolution paying a lump-sum payment of $9 billion for their 70 percent interest in the venture.

Rather than concentrate efforts on the next big hit Drug Revolution had decided to manage its R&D like a portfolio by outsourcing innovations through partnerships. Drug Revolution’s strategy was to supplement its internal R&D with strategic alliances with external companies in order to access high-quality products in late-stage development or recent approval. Because of encouraging results of Grace Pharmaceutical’s limited launch of the drug, management believed that Zipit would be launched full force in the U.S. immediately and in Europe starting 2019. The possible joint venture between Drug Revolution and Grace Pharmaceuticals would concern only the U.S. and European markets. Depending on market conditions (e.g. competition, health-care policies, patents and market need), the remaining life cycle of Zipit drug is estimated at 18 years including year 2018.

Market Characteristics

The target markets for Grace Pharmaceuticals were patients with mild to moderate arthritis who would be treatable with an NSAID category drug. Drug Revolution’s projections show that there are approximately 250 million current prescriptions filled each year for these types of ailments. Drug Revolution estimates a compounded annual growth rate of 3 percent over the last 10 years, driven by multiple factors including the aging of the population and increases in the incidence of chronic illness. They feel comfortable that the 3% growth rate will continue in the US for the length of the project. Europe has the same number of prescriptions for forecasting purposes, with the prescriptions growing at approximately 2% annually. These growth rates were expected to continue into the near future.

Forecast of Income Statements

Since many factors vary predictably with the volume of sales, the primary variable forecasted was Zipit revenues. People with aspirin-sensitive asthma or allergic reactions due to aspirin or other NSAIDs should not take Zipit. Prescription Zipit should be used exactly as prescribed at the lowest possible dose for the shortest time needed. The team projects that after being fully rolled out in the U.S. market during 2018 the drug is expected to enter the European market the following year. It is estimated that 60 percent of the U.S. market would be eligible for the drug, while this ratio might be lower (50 percent) for the European market. Many factors are expected to influence revenues.

Peak penetration rate in the market: Based on different marketing analyses and analysts’ reports, the best guess of market penetration for the drug are seen in below:

Market	2018	2019	2020	2021	2022	2023	2024	2025	2026
Penetration	7.00%	15.00%	20.00%	35.00%	35.00%	35.00%	35.00%	35.00%	35.00%

Market	2027	2028	2029	2030	2031	2032	2033	2034	2035
Penetration	35.00%	35.00%	35.00%	35.00%	35.00%	30.00%	25.00%	20.00%	20.00%

Compliance: Not all patients who use the drug will do so faithfully, even with a doctor strongly recommending its use.   The team believes that the most likely compliance rate would be an average of 87 percent. (i.e. The number of actual prescriptions filled in any given year would be equal to (eligible prescriptions)*(percent penetration)*(.87))

Price per prescription: The annual price of the drug per patient would depend on many things, including how many capsules the patient used and competitive pressures on the price that could be charged for the capsules. The joint-venture team had worked up an estimated figure of $150 as the average cost per prescription filled. The $150 figure is to be used for both the US and European sales.

Variable Costs:

Although the variable costs of the drug are hard to pinpoint, they are not the most critical variable in the success of the drug. The team members decided to use the industry average of 40% of annual sales revenues to forecast variable costs each year.

Fixed Costs:

Fixed Costs which would include sales, marketing, and general and administrative expenses are projected as follows (Note: the values are in thousands of dollars):

Fixed	2018	2019	2020	2021	2022	2023	2024	2025	2026
Expenses	4,800	6,950	10,500	12,500	15,000	16,250	17,500	18,500	19,500

Fixed	2027	2028	2029	2030	2031	2032	2033	2034	2035
Expenses	20,500	21,500	23,000	22,000	22,000	22,000	22,000	22,000	22,000

Net Working Capital:

Net working capital for the joint venture is estimated to comprise a 45-day collection period for receivables, a 90-day period for Zipit inventory, and a 45 day period for payables. Below are the overall changes in net working capital for each year. (Note: the values are in thousands of dollars):

Change	2018	2019	2020	2021	2022	2023	2024	2025	2026
In NWC	(1,000)	(10,000)	(13,220)	(23,580)	(57,770)	(84,970)	(78,870)	(39,930)	(21,780)

Change	2027	2028	2029	2030	2031	2032	2033	2034	2035
In NWC	(23,400)	(20,250)	(16,070)	(17,920)	(16,970)	(12,420)	(3,150)	(2,150)	(1,000)

Capital Expenses and Depreciation Expenses:

The team forecasts capital spending of $4.97 billion split over the first three years of the venture (i.e. outflows of $1.75 billion in 2018, $2.42 billion in 2019, and $800 million in 2020). The yearly depreciation used is show below (Note: the values are in thousands of dollars):

	2018	2019	2020	2021	2022	2023	2024	2025	2026
Depreciation	105,000	105,000	297,500	297,500	297,500	297,500	297,500	297,500	297,500

	2027	2028	2029	2030	2031	2032	2033	2034	2035
Depreciation	297,500	297,500	297,500	297,500	297,500	297,500	297,500	297,500	297,500

Cost of Capital:

The last decision that had to be made by the Drug Revolution’s joint-venture team is choosing a required rate of return for discounting the cash flows for the joint venture. The company’s debt currently has a yield to maturity of 10%. The tax rate appropriate for the joint-venture was 30%. Debt constitutes 30% of the cost of capital. Preferred stock usually makes up 10% of all capital and the average current cost of preferred is 14%. Common stock makes up 60% of all capital sources and has an average cost of 16.5%. While the firm expects the drug to be a success they recognize that most new drug ventures come with additional risks and thus have designated a risk premium of 4.6% in addition to the calculated weighted average cost of capital.

Capital Budgeting Analysis:

Set up the Net Income Statement for the joint venture.

Calculate the WACC

Calculate the Joint-Venture’s annual cash flows from the project.

Calculate the Net Present Value of the enterprise value for the overall project prior to the allocated split in revenues and the 9 billion dollar payment?

Assuming Drug Revolution will negotiate a 70% share in the venture and that they pay a lump sum payment of $9 billion in 2018, what is the resulting NPV to Drug Revolution under the base case scenario?

How much will Grace end up with including the $9 billion cash payment under the base case scenario?

Should Drug Revolution enter into this joint venture using only the base case scenario? Explain your answer.

As a way of understanding how sensitive their numbers are to sales forecasts Drug Revolution has decided to analyze the NPV using a sensitivity analysis based off the Total Revenue for all sources of income line on the proforma statement. Drug Revolution will use a +/- 20% of Total Global Sales Revenue to estimate how sensitive their NPV results are to changes in total global revenue. Determine what the NPV for each of these scenarios would be.

Assume the base case is assigned a probability of occurrence of 60%. Also assume that the best and worst case scenarios have probabilities of 10% and 30% respectively. Given above adjustments what would the expected NPV for Drug Revolution be? Should this analysis adjust your recommendations of an accept/reject decision for Drug Revolution?

What are some of the other methods that are used to evaluate investment projects and compare them to NPV? No specific calculations here, just a discussion. Explain some of the potential drawbacks in this specific case with using the other investment evaluation methods.

Would it be possible to calculate the IRR of this joint-venture? You do not have to do the calculation, but discuss if it is possible to do and if there would be a problem calculating the IRR in this specific problem.
Appendix 1: Sample First Year Proforma Income Statement

Forecasted Income Statement ($000’s)
Joint-Venture
	2016
Market Penetration
U.S. Market prescriptions filled
Eligibility
Total Eligible U.S. prescriptions
European Market prescriptions filled
Eligibility
Total Eligible European Prescriptions
Total Customer Base Both Markets
Total Revenues($000)
Variable Costs (000’s)
Fixed Expenses (000’s)
Depreciation (000’s)
EBIT (000’s)
Tax (@30%)*
Net Income (000’s)
* Note: Assume there is no tax effect if EBIT is negative.

Appendix 2: Sample Free Cash Flow Calculation

Drug Revolution/Grace Pharm Joint-Venture
Forecast of Cash Flows (000’s)
	2016
Net Income
Add back depreciation
Net Operating Cash Flow
Net Working Capital
Change in NWC
Recovery of NWC
Total Change in NWC
Capital Spending
Initial Outlay

Free Cash Flow: