In early 2013, Kieran Gregory, 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.

Zipit, was introduced to the US market by Grace Pharmaceuticals in 2009 after it was approved by the FDA that same year. While Grace Pharmaceuticals has done a decent job of marketing Zipit, the company doesn't 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 $25.9 million of 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, president and CEO 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 Revolutions 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 2030. 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 25.9 million 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 Pharmaceuticals limited launch of the drug, management believed that Zipit would be launched full force in the U.S. immediately and in Europe starting 2014. 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 average life cycle of Zipit drug was estimated at 18 years including year 2013.

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 projects a compounded annual rate of 5 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 5% 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 6% annually. These growth rates were expected to continue into the foreseeable future.

Forecast of Income Statement

Since many factors varied 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 2013 the drug is expected to enter the European market the following year. It is estimated that 90 percent of the U.S. market would be eligible for the drug, while this ratio might be lower (85 percent) for the European market. Many factors were 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 Table 1 below:

Market

2013

2014

2015

2016

2017

2018

2019

2020

2021

Penetration

7.00%

15.00%

20.00%

35.00%

45.00%

45.00%

45.00%

45.00%

45.00%

Market

2022

2023

2024

2025

2026

2027

2028

2029

2030
Penetration

45.00%

45.00%

45.00%

45.00%

45.00%

30.00%

25.00%

20.00%

20.00%
Compliance: Not all patients who used the drug would do so faithfully, even with a doctor strongly recommending its use. The team believed 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 $300 as the average cost per prescription filled.

Variable Costs:

Although the variable costs of the drug were hard to pinpoint, they were not the most critical variable in the success of the drug. The team members decided to use the industry average of 30% of annual sales revenues to forecast variable costs each year.

Fixed Costs:

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

Fixed

2013

2014

2015

2016

2017

2018

2019

2020

2021

Expenses

4,800

6,950

10,500

12,500

15,000

16,250

17,500

18,500

19,500

Fixed

2022

2023

2024

2025

2026

2027

2028

2029

2030
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 would comprise a 45-day collecting period for receivables, a 90-day period for Zipit inventory, and a 45 day period for payables. Below was the overall change in net working capital for each year. (Note: the values are in thousands of dollars):

Change

2013

2014

2015

2016

2017

2018

2019

2020

2021

In NWC

(100)

(1,000)

(1,322)

(2,358)

(5,777)

(8,497)

(7,887)

(3,993)

(2,178)

Change

2022

2023

2024

2025

2026

2027

2028

2029

2030
In NWC

(2,340)

(2,025)

(1,607)

(1,792)

(1,697)

(1,242)

(315)

(215)

(100)
Remember that an increase in NWC is a cash outflow, so we use a negative sign in this table to indicate an additional investment that the firm makes in net working capital. Keep this in mind when you are calculating the project's annual cash flows. In addition, the total NWC from the above table should be recovered at the end of the projects life. (i.e. 44,445 (in 000's) should be added back in during year 2030). See recovery of NWC in your textbook for a complete discussion of this topic.


Capital Expenses and Depreciation Expenses:

The team forecasted capital spending of 7.1 million, split over the first three years of the venture (i.e. outflows of 2.5 million in 2013, 2.6 million in 2014, and 2.0 million in 2015).

The yearly depreciation used is show below (Note: the values are in thousands of dollars):


2013

2014

2015

2016

2017

2018

2019

2020

2021
Depreciation

400

400

950

950

950

950

950

950

950

2022

2023

2024

2025

2026

2027

2028

2029

2030

Depreciation

950

950

950

950

950

950

950

950

950

Cost of Capital:

The last decision that had to be made by the Drug Revolution's joint-venture team was choosing a cost of capital for discounting the cash flows for the joint venture. A common practice in the industry was to use a 20 - 25% discount rate for products in advanced clinical trials. Since this drug has just been approved recently they chose a slightly lower hurdle rate of 18%. The tax rate appropriate for the joint-venture was 38%.

capital Budgeting Analysis:

1. Set up the Net Income Statement for the joint venture. I have gotten you started with a file named Drug Revolution Grace Spreadsheet.

2. Calculate the Joint-Venture's annual cash flows from the project. You may also find it most helpful to have all numbers in $000's.)

3. Calculate the Net Present Value of the overall joint venture prior to Drug Revolution's payment of 25.9 million.

4. Assuming Drug Revolution will negotiate a 70% share in the venture and that they pay a lump sum payment of 25.9 million in 2013, what is the resulting NPV to Drug Revolution? Should Drug Revolution enter into this joint venture? Explain your answer.

5. What are some of the other methods that are used to evaluate investment projects and why are they inferior to NPV? No specific calculations here, just a discussion. Explain some of the draw back in this specific case with using the other investment evaluation methods.

6. Would it be possible to calculate the IRR of this joint-venture? What are the possible problems if any with its calculation in this specific problem? In general, why is the NPV assumed to be superior to the IRR?