Quantitative Methods for Business Decisions PART 1

1
Vertical Boundaries of the Firm
2
NUCLEON

• The date is December 1990
• Nucleon is a small biotechnological company
  specialized in RD, no manufacturing capabilities
• Potential products CRP (cell regulating protein)
  and 2 other products
• In order to get to the market the drug must be
  approved by FDA-gtsuccessful clinical trials

3

• Dillema Vertically integrate downstream into
  (pilot) production or buy the production on the
  market

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The Firm in The Vertical Chain

• Begins with the acquisition of raw materials
• Ends with the sale of finished goods/services
• Includes support services such as Finance and
  Marketing
• Organizing the vertical chain is an important
  part of business strategy

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The Position of the Firm in a Vertical Chain

• For each step in the vertical chain the firm has
  to decide between market exchange and vertical
  integration
• The degree of vertical integration differs
• Across industries
• Across firms within an industry
• Across transactions with in firm

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Vertical Boundaries of the Firm

• The Firm has to make a decision on
• which steps of the vertical chain are to be
  performed inside the firm
• which steps of the vertical chain are to be
  out-sourced
• Choice between the invisible hand of the market
  and the visible hand of the organization (Make
  or Buy)

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Vertically Integrated Firms

• Some firms choose to outsource many of the
  vertical chain tasks and become vertically
  disintegrated. Example Nike

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Make versus Buy

• Decision depends on the costs and benefits of
  using the market as opposed to performing the
  task in-house.
• Outside specialists may perform a task better
  than the firm can.
• Intermediate solutions are possible. Examples
  Strategic alliances with suppliers, Joint
  ventures

9
Some Make-or-Buy Fallacies

• Out-sourcing an activity eliminates the cost of
  the activity and hence increases earnings.
• Backward integration captures the profit margin
  of the supplier.
• Vertical integration helps insure against the
  risk of high input prices.

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Outsourcing and Cost

• It should not matter if the costs of performing
  an activity are incurred by the firm (Make) or by
  the supplier (Buy).
• The relevant consideration is whether it is more
  efficient to make or to buy.

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Backward Integration and Profits

• The suppliers profit margin may not represent
  any economic profit. Profit margin should pay
  for the capital investment and the risk borne.
• If the supplier is earning economic profit, what
  is the reason for its persistence? Market
  competition should eventually erode away the
  economic profit.

12
Vertical Integration and Input Price Risk

• Instead of vertical integration, forward or
  futures contracts can be used to hedge input
  price risk.
• Another possibility is that the capital tied up
  in vertical integration could be used to set up a
  self insurance fund.
• Vertical integration into a risky activity will
  add rather than reduce the overall risk.

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Benefits and Costs of Using the Market
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Economies of Scale
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Economies of Scale

• A given manufacturer of automobiles may not be
  able to reach the minimum efficient scale (A)
  for anti-lock brakes.
• An outside supplier may reach the minimum
  efficient scale by supplying to different
  automobile manufacturers.

16
Agency and Influence Costs

• The incentives to be efficient and innovative are
  weaker when a task is performed in-house.
• Agency costs are particularly problematic if the
  task is performed by a cost center within an
  organization.
• It is difficult to internally replicate the
  incentives faced by market firms.

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Agency Costs

• To create market-like incentives, managers could
  be given incentive-based pay.
• Incentive-based pay will increase the risk
  exposure for the managers and lead them to demand
  higher base level compensation
• Internal mechanisms for promoting innovation
  often do not work.

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Promoting Innovation Internally

• It may be difficult to evaluate proposals to do
  innovative work.
• Basing the reward on easy-to-measure dimensions
  may result in sub-optimal choices. Example
  Incentives based on the number of new products
  each year will shift the efforts towards
  short-term, incremental innovations.

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Influence costs

• In addition to agency costs, performing a task
  in-house will lead to influence costs as well.
• Internal Capital Markets allocates scarce
  capital. Allocations can be favorably affected
  by influence activities.
• Resources consumed by influence activities
  represent influence costs.

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Costs of Using the Market

• Coordination of production flows through the
  vertical chain may be compromised.
• It may be difficult to protect sensitive private
  information.
• Some transactions costs could be avoided by
  performing the task in-house.

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Coordination Problems

• Some examples
• If the supplier does not deliver certain parts on
  schedule, the factory may have to be shut down.
• Lack of coordination in advertising images in
  local markets can undermine the value of the
  brand.
• Unexpected cancellation of a course by a foreign
  university may delay the graduation of exchange
  students.

22
Leakage of Private Information

• Firms would not want to compromise the source of
  their competitive advantage. Hence some
  activities cannot be out-sourced.
• Sometimes, contracts can be used to protect
  against leakage of critical information.
  Example Non-compete clause for employees

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Transactions Costs

• Out-sourcing entail costs of negotiating, writing
  and enforcing contracts.
• Costs are incurred due to opportunistic behavior
  of parties to the contract and efforts to prevent
  such behavior.
• Transactions costs explain why economic
  activities occur outside the price system.

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Back to the case Methodology

• Use decision tree for determining possible
  scenarios
• Number of factors has to be considered
• Qualitative arguments (pros and cons of every
  alternative)
• Organizational change
• Technology transfer costs and risks
• Long term strategic options
• Other
• Quantitative arguments (Financial returns-NPV)

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Biotechnology

• Biotechnology a relatively new field
• Nucleon one of over 200 companies, most of them
  specialized in RD.
• Companies racing to be first to clone a gene
  (proprietary position)
• CRP attractive niche
• Burn wound treatment
• Kidney failure

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Biotechnology

• Strategies of BT companies -gt most RD, some
  integrated into manufacturing, some even into
  marketing

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Legal framework

• Competition was mostly in RD establishing a
  strong proprietary position was crucial
• Risks of establishing a strong proprietary
  position
• New legislation (difficult to predict court
  rulings)
• Time demanding to obtain a patent
• Most companies could not wait until patent was
  granted (time lag)

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Drug development process

• Drug development process was very complex
  (growing genetically altered bacteria was very
  much an art)
• Nucleon currently produced quantities well below
  those needed for clinical trials (scale up 10x)
• Due to complexity of process scaling up was
  unpredictable

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Human clinical trials

• To get FDA approval drug had to undergo three
  phases of clinical trials
• Phase 1 trials assessed basic safety -adverse
  reaction (6-12 months)
• Phase 2 (determining appropriate dosages on a
  small sample-gt1-2 years)
• Phase 3 trials assessed products efficacy
  (multiple hospitals and large number of patients,
  2-5 years)

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Financial environment

• Poor capital availability (buyers market)
• Venture capitalists expected returns of 30
• Nucleon just about to receive another 6 mil
  from its venture capitalist
• With additional infusion (6 mil ) and cash on
  hand, Nucleon had about 6,5 mil .
• Market analysts expected that situation on
  capital market would improve in 1992

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Manufacturing options for clinical trials

• Three different options for Phase I and II
• The new pilot plant
• Contract manufacturing
• Licensing product to another company
• Two options for Phase III
• V. I. into commercial manufacturing
• Licensing out manufacturing and marketing rights
  at Phase III

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Scenario breakdown with a decision tree
V.I. into manufacturing
Pilot production
Licensing out
V.I. into manufacturing
Contract manufacturing
Licensing out
Licensing out
Licensed out
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Phase I and II three options
Pilot production in the new pilot plant
Contract manufacturing outside the firm
Phase I and II
Licensing out in Phase I
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The new pilot plant

• Pilot plant capacity (600 m2) would meet
  Nucleons requirements for Phase I and II
• Investment outlay can be found in exhibit 3
• The pilot facility could however not be used for
  Phase III (stricter requirements)
• It was beyond Nucleons financial capability to
  build such a plant at this time

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Contract manufacturing

• Biggest advantage no major capital investment (if
  CRP failed contract could be easily terminated)
• Companies offering contract manufacturing had
  facilities and their personnel in place
• Contract manufacturing not inexpensive (see
  exhibit 4)
• Industry experts believed that excess capacity
  would accumulate in the future
• Much time needed to transfer process due to high
  complexity

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Licensing out-Phase I

• Nucleon could license the product immediately
  (before human clinical trials)
• Get 3 mio cash on hand (immediatelly) and
  royalties equivalent to 5 of gross sales (upon
  FDA approval)
• Gross sales estimates (exhibit 5)

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Phase III two options
Vertical integration into manufacturing
Phase III
Licensing out in Phase III
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Vertical integration into commercial
manufacturing

• Before Phase III Nucleon could V.I into
  manufacturing
• 21 Mio required to perform scale up (provided
  by venture capitalist if intermediary results
  promising)
• If FDA approved the drug Nucleon received 5 mio
  upon FDA approval and royalties equal to 40 of
  the partners gross sales

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Licensing out in Phase III

• Under this option Nucleon could expect to receive
  7 mio upon FDA approval of the drug and
  royalties equivalent to 10 of the partners
  gross sales

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Study question

• What are your recommendations regarding Phase
  III ? What are your recommendations regarding
  Phase III ?
• Pilot plant might be used for other projects
  (products). Estimate how much can Nucleon save on
  variable expenses by investing in pilot plant

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Pros and cons (Phase I and II)
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Pros and Cons (Phase III)
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Financial analysis

• Calculate NPV
• Estimate operating CF (exhibit)
• Discount factor (30 )
• General approach (use different discount factors
  according to risk of each CF)
• Estimate value of real options

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Calculating NPV

• Assumptions
• Discount factor 30
• Gross sales represent after tax cash flows
• Sales after 2002 grow constantly at 5
• Depreciation tax shield CF and Phase III cost are
  approximately equal
• How do you feel about these assumptions?

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Example of NPV calculation pilot manufacturing
V.I.
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FCF analysis
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NPV of branches on the decision tree
Phase III Phase III
16.487
production
3.596
pilot
license
19.276
production
contract
license
6.372
license
7.257
license
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Real options

• Pilot plant might be used for other projects
• By investing we save on variable expense
• Investment outlay and variable expenses can be
  estimated from exhibits 3 and 4
• Calculate break-even point

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Real options valuation

• Investment outlay 3,1 mio
• Variable cost savings 0,5 mio

• Break-even point 6 projects

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Financial considerations

• NPV represents expected value of many possible
  outcomes (in reality there is only one)
• Nucleon has only one project outstanding (no
  diversification)
• One aspect to consider is preference of venture
  capitalist

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Long term strategic options

• RD company
• RD with pilot manufacturing capabilities
• Integrated manufacturing enterprise