A8_solutions

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36106 Managerial Decision Modeling Hand-in Assignment #8 (Solutions) Rules: 1. This is a group work assignment. 2. There is 1 question. 3. Submit your excel file with working @RISK and Solver models through Canvas by the time indicated. Turn in your hardcopy report at the beginning of the lecture . Question 1. [20 pts] Read the Genzyme/GelTex Pharmaceuticals Joint Venture case. The case portrays several aspects of a joint venture situation, which include strategic aspects of the venture, deterministic cash flow anal- ysis, and dealing with uncertainty surrounding many components of the venture among many others. The case presents (in Exhibits 3 and 4) a completed deterministic valuation analysis, which shows that the NPV of a 50% interest in the joint venture is about 17 million. We will extend this deterministic analysis to capture the discussed uncertainties through Monte Carlo simulation analysis. You will need the @RISK add-in to complete this assignment. The deterministic model provided in Exhibits 3-4 in the case is also available in the spreadsheet file Gen-Gel.xlsx on Canvas under Assignments. You should carefully go through the formulas in this Excel file while simultaneously reading the case to visualize the process of computing cash flows. Answer the following questions considering the Genzyme/Geltex case: (a) [8 × 3 4 = 6 pts] Tabulate a list (see an example below) of the uncertainties discussed in the case along with your choice of distributions to model them. Note that there is no absolutely correct answer; but there are some good answers and bad answers. Answer: Uncertain variable Distribution Justification for choice FDA approval/market launch RiskBernoulli(.65) Page 7 of the case Launch delay RiskDiscrete( { 0, 1, 2 } , { .7, .2, .1 } ) Page 7 of the case Lifecycle of drug RiskTriangular(10, 13, 20) Page 7 of the case Peak penetration rate RiskTriangular(.2, .5, .59) Page 8 of the case Compliant patients RiskTriangular(.75, .92, .94) Page 8 of the case Price per patient RiskTriangular(600, 1100, 1300) Page 8 of the case Profit margin RiskNormal(.7, .05) Page 8 of the case Marketing cost multiplier RiskTriangular(.87, .93, 1.2) Page 9 of the case

Business 36106 Assignment 8 (Solutions) I will model the “Discount rate” as a deterministic parameter with a value of 20%, but also note the following: Considering the discussion on page 9 of the case, one can also think of modeling the discount rate as an uncertain variable. If you choose to do so, one can use RiskUniform(.2, .25) (per the discussion on page 9 of the case). Another alternative approach is to think whether the simulation model actually captures all the risks in the cash flows. If we have reason to believe that the model indeed does capture all the relevant risks, then we would model the discount rate as a deterministic parameter and simply pick the risk-free rate (typically, around 5%). However, most practitioners doubt that simulation models capture all relevant risks (e.g., competitors) and they employ discount rates with large risk premiums over the risk-free rate (that is actually the approach being employed in the biotech industry as evidenced with the 20%-25% discount rates). Yet another approach would be to realize that Genzyme’s NPV is affected by the risks involved in the joint venture, which is some weighted average of the risks faced by Genzyme and Geltex. As a result, one can also argue that the appropriate discount rate may be modeled as RiskUniform(.1475, .23), or a deterministic weighted average given by the share of the Genzyme and Geltex in the joint venture. (b) [3 pts] Use a Tornado chart to find which of the parameters you have listed in part (a) have the largest influence on Genzyme’s NPV? Note: You can either use Tornado charts available through the Sensitivity Toolkit add-in (from Week 1), or Tornado charts included with @RISK (Advanced Analysis ≫ Advanced Sensitivity Analysis). You will need to manually specify the maximum and minimum values because the default options may not allow capturing the entire range of values for the given parameters. Answer: I have set the base value for all the uncertain parameters to the values in the determin- istic model, and chose the two additional values as the minimum and maximum. For the profit margin, I chose mean ± 3 standard deviations as the min and max values. As the picture implies, when taken individually, the 4 parameters that have the highest impact on Genzyme’s NPV are: (1) peak penetration rate, (2) price per patient, (3) FDA Approval, launch, 2

Business 36106 Assignment 8 (Solutions) and (4) Gross profit. (c) [3 pts] Taking one parameter at a time, tabulate the individual best and worst case values of the parameters listed in part (a) for Genzyme. Take all the individual best case values simultaneously and report the associated best case NPV. Repeat the same thing for the worst case values and report the worst case NPV. Considering these results, if you were in Phelps position, are you ready to make an investment decision? Why, why not? Answer: Parameter Best case Worst case FDA approval/market launch 1 0 Launch delay 0 2 Lifecycle of drug 20 10 Peak penetration rate 59% 20% Compliant patients 94% 75% Price per patient 1300 600 Profit margin 85% 55% Marketing cost multiplier 0.87 1.2 Genzyme’s NPV (in thousands) 154,482 - 27,500 Note that if we use all the values from the “Worst case” column, but replace FDA approval to 1, then we get an even worse scenario with NPV of -57,962. Either answer is acceptable. Although there is huge positive NPV in the best-case scenario, the fact that there is a non-negligible negative NPV in the worst-case scenario makes it infeasible/hard to jump into a conclusion. Given the wide range of possible NPVs, it might be preferable to see the likelihood of positive/negative NPV, which we will achieve through a detailed simulation analysis in the next part. (d) [1+1+1 pts] Now use @RISK add-in to implement your distributional choices from part (a) in order to translate the provided deterministic model to a stochastic simulation model. Take 1000 iterations of the resulting model. What is Genzyme’s expected NPV? What is the probability that Genzyme’s NPV turns out negative? Would you invest now? Why, why not? Answer: The chart below indicates that Genzyme’s expected NPV is around - 2 million and that the probability that Genzyme’s NPV will be negative is around 56%. This chart clearly demonstrates that the best-case scenario reported in part (c) is extremely unlikely to occur. However, worst-case scenario has a much higher likelihood of occurrence. On top of that, the fact that expected NPV is negative and that probability of a loss is drastically large, I would back off from this joint venture opportunity. (e) [2+3 pts] The calculations in part (d) assume a 50:50 split between Genzyme and GelTex. As in the base-case, assume that Genzyme is willing to invest 27.5 million and that its decision criterion is based on expected NPV. What is the minimum percentage share that it should ask for so as to invest into this venture? Use 10,000 iterations for each simulation and answer to the closest integer. What if the decision criterion was to lower the probability of a negative NPV to below 50%? ( Hint: You can use RiskSimtable to answer this question) 3

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Business 36106 Assignment 8 (Solutions) Answer: For mean NPV of 0, Genzyme should ask for a 54% share. For a 50% chance of positive NPV, Genzyme should ask for 64% share. The final RiskSimtable is below (See tab “ (d) @RISK model ” in Gen-Gel solution.xlsx ): RiskSimTable 4