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CBS Managerial Economics II April 2014 3 day exam case

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The case of

PharmaGroup Managerial Economics II

Final Exam

STU: 58984

Word Count: 9428

Written from April 5th to April 8th 2014

Student Name CPR

Ida Maria Frederiksen 220293 - xxxx

Victoria Helene Kisling 130894 - xxxx

Nina Munch Jørgensen 270693 - xxxx

Emma Louise Randlev Bramsen 260993 - xxxx

JeppeMulvadJensen

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JeppeMulvadJensen

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JeppeMulvadJensen

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JeppeMulvadJensen

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1) By making use of your own assumptions and research make an external analysis of the market that PharmaGroup is operating in PharmaGroup is a large global company, which operates within the pharmaceutical industry. The industry is characterized by constant growth and large entry barriers, which makes it costly for new companies to enter. Therefore the competition in the market is concentrated around a few but important competitors. When conducting an external analysis of the market an organization operates within, it is important to focus on both the general and competitive environment. The general environment concerns factors of a macro-economical character such as political, social or technological factors. The competitive environment is made up of the industry and markets in which an organization participates. While both environments are of great importance when analyzing external factors of a given market, it should be noted that the competitive environment affects the organization most directly. However, it is still crucial that the general environment is examined, because organizations repeatedly must scan and monitor macro-economical factors in order to forecast changes that will affect the competitive environment. Scanning the general environment makes the organization attentive to weak signals, which then are followed closely through monitoring in order to assess whether these weak signals should be considered as threats that could influence the market. An effective tool to make use of when scanning the general environment is the PEST analysis, which evaluates the importance of and change in the Political, Environmental, Social and Technological factors. This will provide PharmaGroup with a valuable overview of potential risks that they should try to avoid through their strategy. Among the political factors to be considered in the pharmaceutical industry are governmental policies and regulations, stability, and legislations. A pharmaceutical company is sensitive to changes in government policies and regulations since these can have great impact on the developmental stages of their products; ethical questions regarding animal testing of drugs is a repeating issue which yields debate as the validation of the results are questioned along with the moral status of using animals in these types of experiments. A ban of animal experiments would be costly for the pharmaceutical companies as it in extreme situations would result in either human testing or distributing untested medicine on the market; both are unthinkable situations, however the threat of banning animal testing is real, and the pharmaceutical companies must therefore consider alternatives such as the 3 R’s: Reduction, Refinement, and Replacement which would result in vast changes in the developmental procedures and would require large investments by the pharmaceutical companies in the industry (BBC, 2014). Due to governmental legislation, different markets have different laws regarding the composition of the various drugs in medicine. In order for a pharmaceutical company to achieve the needed approval for a newly developed drug, they must submit it to go through a validation process where the drug is tested by a governmental institution to establish the efficiency of the drug. FDA is the regulative institution, which regulates pharmaceutical products in North America and EMEU in the European Union (Castner, Hayes & Shankle, 2007). This process is rather costly for the company as the procedure can


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be prolonged. Furthermore the risk of a rejection of the drug or the banning of a drug already on the market is a big threat, because this would make large investments and R&D processes go to waste. The economical factors to be considered in the general environment are factors concerning the interest rate, unemployment, economic growth, disposable income and “Me-too” drugs. PharmaGroup is expanding into new emerging markets, respectively India and China, which are facing a high economic growth rate. This leads to higher disposable income for the citizens, generating a higher demand for pharmaceutical products, since more consumers now can afford health care. These emerging countries have unexploited markets with unmet needs with regards to pharmaceutical products, creating opportunities with great profit for PharmaGroup. Another important issue for the company to be aware of are the “Me-too” drugs, which are the cheaper copies of an already existing drug. This leads to more competitors in the market and therefore more competition; PharmaGroup may therefore in time be forced to set their prices according to competition in each country to be able to compete on the pharmaceutical market. Social factors include cultural differences, demography, population growth and change in expectations. Most countries face demographical problems with an uneven ratio of the population with too many elderly citizens. This is a big opportunity for PharmaGroup since people of a higher age statistically have more diagnoses especially movement disorders and thereby require more medication. Movement disorders are of the type of disorders, which are not determined by social or geographical factors; a movement disorder can therefore hit all individuals. This creates an interest for the disease in wealthy countries and will typically lead to financial support for developing appropriate medicine. Another factor evolving is the situation concerning black magic and the cultural differences that coincide regarding this topic. The Eastern population has a completely different historical and therefore also cultural background, which for many years has made them highly skeptical towards new types of medication. However, due to a gradual Westernization of the East, these countries have learned to adopt Western habits more readily, which especially can be seen by the fact that black magic recently was banned in India (Sakal Times, 2013). This will over time create a higher demand for more modern products such as the ones PharmaGroup are offering.

It is very important to consider the technological factors affecting the general environment. The R&D sector is forced to grow at a rapid speed, especially in the pharmaceutical industry in order to stay competitive with other companies on the market. Furthermore, production facilities become increasingly expensive due to the technological complicity of the instruments used in the production processes. This creates a very heavy economical load on any given organization within the industry, making entry barriers higher and even forcing companies out of business. PharmaGroup has to learn to adapt quickly to the rapidly growing technological changes within the industry. However, this means


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that the monitoring is essential in regards to technological factors in the industry in order for the companies to remain up to date with the competition. Having examined the general environment, we now have a framework, which will facilitate the analysis of the competitive environment. For this analysis, Porter’s Five Forces has been chosen as the appropriate tool to evaluate the industry. Porter’s five forces will provide an overview of whether PharmaGroup stands strongly in relation to their industry. The five forces framework is an assessment of threats of new entrants, bargaining power of suppliers, threats of substitute products, and intensity of rivalry among firms in an industry. Looking at the threat of new entrants, PharmaGroup is in good standing as they are already one of the key companies in the industry itself. As the entrance barriers are high due to the technological changes described in the PEST-analysis, threats of entry by new pharmaceutical companies will be low. Starting costs in the pharmaceutical industry are extremely high, forcing organizations to exhaust economies of scale in order to generate profits. It is therefore risky for new companies to enter the market as they face huge capital investments while at the same time trying to adapt their product to the different government policies and regulations. However, when concentrating on only the Asian market, PharmaGroup does face an obstacle, because their products are still somewhat unknown. This means that customers will be more prepared to switch to other alternatives. When evaluating the bargaining power of buyers it depends on whether the product PharmaGroup offers is standard or differentiated. If the product is standard buyers have high bargaining power because they can readily find a new replacement; this is the case when there are several “Me-too” products available. However, if the product is differentiated the buyers have very low bargaining power, because alternatives are limited. The assumption is that PharmaGroup supplies a rather differentiated product since there are only few competitors on the market. The bargaining power of suppliers is also low, as the pharmaceutical industry has several different suppliers for the necessities required to produce their products, for instance the chemicals. Organizations can therefore easily switch between suppliers, which gives PharmaGroup a competitive advantage. When investigating the threat of substitutes it is essential to consider the high costs associated with the development of products similar to those PharmaGroup offers. Generic drug companies such as PharmaGroup have already invested huge amounts of money in Research and Development to create the product they now have on the market. Threat of substitutes is therefore considered as medium, since it is possible for competitors to offer substitute products, especially through knock-offs, when the patent of the original product has expired. But since the costs of doing this are so high new organizations are unwilling and unable to even try to create potential substitute products. The rivalry amongst competitors is high since the pharmaceutical industry is characterized by high growth and many strong competitive players who all compete intensively for the same consumer cartel. All in all, according to the Porter analysis, PharmaGroup are placed relatively well in relation to their


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industry. The biggest threats are those of “Me-too” products, where other organizations imitate PharmaGroup’s products. 2) Describe the internal and external view on strategy development and provide suggestions as to how you see PharmaGroup should develop their business strategy In order to provide a business strategy for PharmaGroup it is relevant to carry out a SWOT-analysis, as it enables a company to assess the fit of its current strategy to its changing environment. SWOT provides an analysis of the strengths, weaknesses, opportunities, and threats the organization faces, thereby helping to formulate the strategy of the company. The strength of a market leader like PharmaGroup is that they have a strong brand and have a good reputation among consumers; although they mostly enjoy this in the Western markets. Due to the good reputation they have favorable access to consumers and as it is a global company, they have experience from a variety of different markets, which gives them a lot of know-how in this industry. As one of the largest global companies within the area of pharmaceutical solutions for treatment of movement disorders PharmaGroup enjoys the benefit and strength of holding the patent of various products, which gives them an advantage in the market. However the strength of holding a patent can turn into a weakness due to the limited time for a patent to be held. This allows for other pharmaceutical companies to copy the product and sell it cheaper, as they do not have the great investment of obtaining R&D. This leads to higher competition in the market and thereby forces the company to lower their prices in order to keep market share. Because of the long and expensive development each product goes through, there are great risks involved for pharmaceutical companies, since they invest great amounts of money into e.g. R&D and advertising without being certain of the product’s validation. The validation depends on government legislation, which is a great weakness for pharmaceutical companies, as this is a factor, which is difficult for the pharmaceutical industry to control. PharmaGroup have many unexploited opportunities as the high growth in the developing countries increases the demand and expectations for the pharmaceutical industry; the human needs are unfulfilled. Currently there is a lot of pressure towards government institutions from many of the big and well-known pharmaceutical companies. They request less regulation, which increases the chance of looser regulation in the future (Drinkard, 2005). The different entry barriers to each country poses as a threat to the pharmaceutical companies, as it complicates their expansion to new markets and thereby detains the company further economical growth. A threat to PharmaGroup is the large availability of substitute products in the market, the so-called “Me-too” drugs, which allows consumers the same medical effect to a lower price; parallel trade composes the same threat, where products from a cheaper market are sold illegally to an expensive market to a lower price.


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PharmaGroup would benefit from pursuing a focus strategy, where the company aims at serving a specific segment of the market; this puts the company in a first-mover position and allows them to be the first to develop the best products to meet the need of the consumers. Over time this will benefit PharmaGroup since it will enhance their reputation as the best pharmaceutical company to create medicine against movement disabilities. This will allow them to make use of their know-how and R&D. As the company is one of the largest in the industry, they should choose a focus-differentiation strategy instead of cost-focus, as the company will benefit more from competing on differentiating than on price. By following this approach, PharmaGroup will be able to focus their resources on developing and improving in this specific area of the pharmaceutical industry, which will allow them to use their resources on achieving the newest and most thorough R&D which will put them in the lead; they will not need to focus as much on marketing, as their strong reputation for quality medication will be enough to secure their market share and consumers. Pursuing a focus-differentiation strategy is especially important since we from the Porter’s analysis derived that a big threat in this industry are “Me-too” products. With high differentiation and focus on a specific segment of the market, they would gain status of a brand with loyal consumers, rather than an organization with a reputation of being inexpensive. The focus-differentiation is the optimal solution for PharmaGroup. However, it may be difficult to maintain a pure strategy, as the market can offer unexpected challenges and changes. Therefore a company might benefit from developing a hybrid strategy, where the organization combines the focus-differentiation strategy with a lowering of their prices to achieve the higher market share. They should attain this by reducing their costs. Still, it is important to keep in mind that they should only lower their costs to some extent, as they as a market leader should focus on quality products rather than on discount products; the purpose of lowering their prices is not to distribute the cheapest product, but to increase revenue by attaining the highest market share. This scenario could become real if another market leader develops a similar product at the same time as PharmaGroup.


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3) How can the Boston Consulting Group Matrix be particularly helpful for companies like PharmaGroup? The Boston Consulting Group Matrix charts an organization’s business units according to industry growth rate and relative market share (figure 1).

An industry that is growing faster than the economy is characterized as a high growth industry, while an industry growing slower than the economy is an industry with low growth rate. In the Boston Consulting Group Matrix businesses can be defined as stars, cash cows, questions marks, or dogs. Their definition depends on the growth rate in the given industry and the market share of the particular company. A star is identified by high growth and high market share whereas a cash cow is characterized by a high market share and a low industry growth. A question mark has low market share and competes in a high-growth industry, and a dog has low market share in a low-growth industry. A company like PharmaGroup can use the matrix to analyze their possible entrance into a new market. For instance, the Eastern market has a high growth rate, which makes it possible to become a star in the


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market if they have a successful entrance, which allows them to gain high market share (above 1). A market like the European market has more constant growth rates, but assuming that PharmaGroup have a high market share, they have already reached the status of “cash cow” in Europe. The BCG matrix is a relevant tool as it takes the industry’s growth rate into account. However, this is also the downside regarding the tool, since when it only takes industry growth rate and market share into account, it misses other relevant and variable factors. The importance of the market share might be overemphasized as major companies can fail to enter a market, if the top management is not able to perform the necessary branding of the product in the new market. 4) Provide your own assessment of the business risk for this investment Business risk is influenced by numerous factors, which must be taken into consideration when a company shapes its business strategy. According to the theory of the firm an organization’s main concern is to maximize the wealth and value of the firm; this means that precautions must be taken if the investment is of high risk. The riskiness of the project can be evaluated through a PEST analysis, which was provided in question one. Our conclusions to this analysis were that especially the political and economical factors could make the future of the organization uncertain. The development of new products poses as a great risk for pharmaceutical companies due to the large capital investments that must be placed in order to gain the satisfying amount of R&D needed; furthermore, the companies face prospects that new pharmaceutical products do not get the required approval to enter the market. Under those circumstances, the financial investment would prove to be unprofitable. For PharmaGroup, the development of their new product, Xiquinon, is a great economical expenditure, as it requires capital investments of 141 million euros before the product is expected to start selling on the market. Therefore there is a great amount of risk involved in the investment; if PharmaGroup have overestimated the demand of the market they will be facing great capital loses, as the invested capital is irreversible. On the other hand, Xiquinon might generate several positive cash-inflows, which will increase throughout the first five years of introduction, and possibly continue to do so as the product is established on the market. This can be reflected by the Product Life cycle, which shows how revenue is small in the introduction stage of a product and how revenue increases in the growth and maturity stage. The potentially high revenue gain outweighs some of the big risks associated with the investment, since the product could gain high market share but with a somewhat low growth rate and thereby gain the status of cash cow according to the theory of the BCG matrix. Another way to assess the riskiness of the business is to consider the firms operational leverage, otherwise known as DOL. Operational leverage outlines the ratio of a firm’s total fixed costs to total variable costs; if there is a high ratio of fixed cost the firm is more leveraged, which implies that a firm’s profit is more sensitive to changes in sales. It is possible to calculate this sensitivity mathematically by calculating the degree of operating leverage by using the formula beneath.


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𝐷𝑂𝐿 =%∆𝜋%∆𝑄 =

∆𝜋/𝜋∆𝑄/𝑄 =

∆𝜋∆𝑄 ∗

𝑄𝜋

The R&D which PharmaGroup uses to develop their products are very costly, so the ratio of fixed cost is very high for the company; this means that the company is very sensitive to changes in sales or output, which generates higher profit in the long run. 5) How could PharmaGroup try to reduce the business risk as much as possible? In order to reduce some of the business risks associated with investing into new products it would be beneficial for PharmaGroup to make use of scenario planning; this tool can be used to make more favorable strategic decisions and thereby enhance corporate perception, as it allows the company to imagine different circumstances, and under these change all thinkable variables which exists in both the internal and external environment of the company. Through these scenarios, the company can adopt its actions to gain the most efficient outcome. Scenario planning is especially beneficial when real options are available. In the presence of real options, a given organization has the option to continue with their investment at different stages in the investment process. This flexibility is very valuable since it allows PharmaGroup to undertake a thorough investment analysis before investing the 87 million euros in year 1 and 23 million euros in year 2, thus meaning a huge economical save if the investment analysis shows a negative reception of the product before final production has taken place. A measurement PharmaGroup can implement to reduce business risk is to have lower fixed costs and instead have higher variable costs. When the investment is of an international character and the company is operating in emerging markets, engaging in cooperative production such as joint ventures, would mean shared and therefore lower costs, thus reducing the business risk. Another way of reducing risk is for the company to have several other pharmaceutical drugs in their pipeline, so that they have the opportunity to quickly discard of a declined product and instead focus on the development of a different blockbuster drug (Class, 2005) . 6) Make a proposal for the discount rate you think should be applied for the investment and provide arguments A discount rate is made by translating all future net cash flows back to present time. To make these cash flows comparable, a company has to apply a discount rate. As the investment can be considered as more risky than the average investment, given the various risks mentioned before, the discount rate should be high. Investors will therefore demand a higher return on their financial means to get somewhat of a risk premium in return. To estimate a discount rate we look at the Weighted Average Cost of Capital, or WACC:


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WACC = we * ke + wd * kd We know that the PharmaGroup already has products on the market, and that it is one of the top organizations in its industry. This means that they are able to finance some of the investment on their own. The more uncertain a company is regarding their future earnings, the higher risk the company is facing. Companies in stable industries with a stable cash flow usually make higher use of debt, whereas companies in unsecure and new industries have to finance a larger part of the investment of own capital. The pharmaceutical industry is large and stable, however there is some uncertainty in developing a new product and going into a new market. Therefore the assumption is that equity is 50%, which leaves a 50% of debt. The cost of equity is higher than the cost of debt, because there is no security in the capital stock and a higher cost of equity is required to satisfy financial institutions. We assume that the cost of debt is 12% and the cost of equity is 20%. Plotting the numbers into our WACC formula, we get:

WACC = 0.5*0.2+0.5*0.12 = 16 % A discount rate of 16% is relatively high and implies that there is a certain risk, when making this investment. 7) Based on the information at hand, do your own financial evaluation of whether the investment is worthwhile pursuing and state all your assumptions Having chosen a discount rate of 16%, cash flows can now be compared over time. The assumption in this financial analysis is that the product, Xiquinon, has a lifespan of 15 years. When doing a financial evaluation of an investment, we have chosen to estimate NPV, IRR and annuity. We are not given any further information about alternatives investments, meaning that we assume that this is a single investment. When estimating a single investment, these three methods will always provide the same result of whether the investment is profitable or not. The net present value (NPV) compare all future cash inflows and cash outflows discounted back to the present time. An investment is considered profitable when the NPV is positive. Applying a discount rate of 15%, we have calculated the NPV on a excel spreadsheet (Appendix 1). Our calculations yield an NPV of 45.699.632,89 EUR, which implies that the investment is profitable. The internal rate of return (IRR) is the discount rate, where NPV0 = 0. The IRR is the break-even discount rate and it is not profitable to invest if the discount rate is above IRR.


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Again, we used excel spreadsheet to calculate IRR (Appendix 1), which gives us a result of 21%, meaning that the investment is again proved profitable as the IRR is higher than the discount rate. The annuity is the average of net present value spread out over the lifetime of the investment. Annuity is mathematically calculated: Calculating the annuity in an excel sheet by the PMT function (appendix 1), we get an annuity of 8.196.572,90 EUR, which is good as the annuity have to be positive if the investment is profitable. When evaluating whether to invest or not, one needs to take into account other investment alternatives. However, in this case the other alternative is to not invest i.e. a NPV equal to zero, meaning that PharmaGroup should invest as it yields a higher NPV. Taking all these method into account, the investment yields a profitable outcome. However, the investment is only profitable if it has a lifespan of 11 years or above, as our accumulated NPV becomes positive from year 11 and onwards. 8) Analyse and provide calculations with regards to the investment uncertainty When looking at the investment in the long run, it will naturally become more uncertain, as a longer time horizon makes it more difficult to foresee different outcomes. However, methods such as assessing critical values, creating different scenarios and using real option can be used to evaluate the uncertainty and sensitivity of an investment. In this case we have chosen to find the critical values and to assess different scenarios. Critical values can be used as an analytic tool to determine the uncertainty of an investment, as it provides the company with useful information on how to reduce risk. By using critical values the company at hand, PharmaGroup, can determine how much a given value in the investment can change before the investment becomes unattractive; normally the company will especially monitor the sales revenue as this is one of the most critical factors. In order to find the critical factors of any given input, the firm must first determine a minimum NPV to see how much a critical factor changes to satisfy the minimum NPV.

𝑁𝑃𝑉 0 = 𝑓 CF, critical factor!

!!!

𝑡 ∗ (1+ 𝑟)

In this investment we have chosen a minimum NPV equal to zero, NPV=0. When calculating the critical values one can either choose to use the equation above or by using excel. In the case of PharmaGroup’s investment we have chosen to calculate the critical values price, quantity and sales revenue by using “Goal Seek” on an excel spreadsheet.


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The critical values of prices are:

We can conclude that PharmaGroup should not sell the product if prices is going to reduce more than 16,1% to a price lower than 9647,77 €. The critical values for units sold:


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This implies that the new drug in the entry period have a relatively low critical value but over time the critical value increases and 7479,97 units should be sold in order for PharmaGroup to make their production profitable. The percentage loss in the sale should not be lower than 17%. The critical sales revenues are:

This information indicates that the critical sales revenue also increases over time, and that PharmaGroup in the end of the lifetime of this investment only can afford a loss in sales revenue of 12%; if the loss is higher, they should stop the production. In the following, our real case analysis will be presented. Our Best case Base case Worst case Price increses by 10% Volume increases by 50%

Nothing changes Price decreases by 10% Volumes decreases by 50%

NPV: 306.260.142,52 EUR NPV: 45.699.632,89 EUR NPV: -183.893.718,13 EUR 30% 50% 20% The expanded business evaluations for the best case and worst case can be found in appendix 2. We assume that there is a 20% chance that the best case will occur, 50% chance that the base case will occur and 20% chance that the worst case will occur. The weighted-average investment model is calculated:

30%*306.260.142,52 + 50%*45.699.632,89 + 20%*-183.893.718,13 = 77.949.115,575 PharmaGroup should still pursue the investment, however the NPV will most likely be lower than before as the weighted-average NPV is positive.


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9) How does the above information impact your above analysis of the investment? State and make your own assumptions in order to build up a presentable business case This question deals with the concept of real options, which means that PharmaGroup has the opportunity to assess the investment at different stages. “Real options” is a powerful tool, since risk is reduced through the value of e.g. financial evaluations. In this particular case PharmaGroup’s initial investments are spread out at three phases. In the first phase, 34 million euros is invested in the product Xiquinon. In the second phase 87 million euros is invested. After this investment has been made PharmaGroup becomes aware of how the investment will turn out. The first possibility is the best case, which would mean that PharmaGroup continue with the product and therefore invest further 23 million euros. The Net Present Value in this case would be the same as before, namely 45.699.632,89 EUR. The second possibility is that the results are mediocre in which PharmaGroup would join forces with another organization in the industry. The Net Present Value in this case would therefore be the previous NPV divided by 2 since we assume that the organizations share the costs and profits 50/50. This yields: 22.849.816,44 EUR. The last possible situation, which we define as the worst case, is a pure rejection of the product after the two first investments have been made, which would result in an NPV of -109.000.000. The difference between this situation with more information and the one before is that the company has the chance to neglect the investment before conducting the third investment if the investment proves to be completely unprofitable. We assume that there is a 40% chance that the best case will occur, a 40% chance that the mediocre case will occur and a 20% chance that the worst case will occur, resulting in abandonment of the investment before the investment of 23 million euros is made. Best Case Mediocre Case Worst Case NPV=45.699.632,89 NPV=22.849.816,44 NPV=-109.000.000 40% 40% 20%

Phase I: Investment = 34.000.000 EUR

Phase II: Investment = 87.000.000 EUR

Best case: NPV = 45.699.632,89 EUR

Mediocre (joint): NPV =

22.849.816,44

Worst case (neglection):

NPV=-‐109.000.000


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NPV is calculated using the weighted-average investment model:

NPV0=0,4*45.699.632,89+0,4*22.849.816,44+0,2*-109.000.000=5.619.779,7 EUR Since now there is a risk that PharmaGroup either will have to engage in a joint venture or neglect the investment altogether after having spent large amounts of finances on investments, the expected NPV will now be much lower. The difference between the expected NPV’s before and now is 45.699.632,89 EUR – 5.619.779,7 EUR = 40.079.853,19. It is evident that the NPV has decreased a lot, but it is important to state that this is due to the risk of the investment being less profitable than before and not because of the presence of a real option, which in this case is to neglect the project before the 3rd investment is made. If this option had not been available to PharmaGroup they would have made the 3rd investment of 23.000.000, but still generating no cash-inflows, meaning that the worst-case situation would result in an NPV of: -126.092.746.73. Using the weighted-average investment model, the NPV yields:

NPV0=0,4*45.699.632,89+0,4*22.849.816,44+0,2*-126.092.746,73=2.201.230,4 EUR. We can therefore, in addition, conclude that when a real option of dismissing the investment is present, the NPV will be larger by 5.619.779,7-2.201.230,4=3.418.549,3 EUR. This illustrates how important real options can be. But overall the investment is now less profitable than before since there is higher risk involved. 10) Illustrate the loan’s cash flow One of PharmaGroup’s banks are offering financing in a form of serial loan, which has to be paid over 12 years quarterly with a grace-period of 3 years. A serial loan is a loan with the same installment paid each year. The illustration beneath illustrates the yearly financing of the serial loan we are considering for PharmaGroup:


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The cash flows of the loan are calculated in an excel spreadsheet which can be seen in Appendix 1. From the illustration we can see that the payment amount decreases over time, and that there is no installment in the beginning of the loan, the so-called the grace-free period. 11) Calculate the effective annual interest rate The effective interest rate is the actual interest rate paid on the loan. It takes compounding into account, which is the process of the exponential increase in the value of an investment, and is therefore almost always higher than the stated annual interest rate. It can be calculated as:

The effective annual interest rate bears resemblance of the internal rate of return (IRR). We calculate the quarterly effective interest rate by using the IRR function in excel which results in a quarterly effective interest rate of 2,1%. To get the yearly effective interest rate we use to the formula for the effective interest rate:

((1+2,1%)^4)-1 = 8,7%


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This gives us an effective interest rate of 8,7%. This will be the interest rate PharmaGroup actually pay in order to repay the financial institute. 12) Apart from the loan’s effective annual interest rate what other issues would you consider? There are several issues to take into consideration the option of taking out a loan. First of all, a thorough examination of the bank, from which the loan is to be obtained, must be performed. If the bank is unstable the interest rate applied will be higher, which means that the discounting rate will increase, causing the investment to be more expensive. This would result in lower profits for the borrower, in this case PharmaGroup. Secondly, if the loan is taken in another country, PharmaGroup should be aware that fluctuations in the currency may occur. This is important to monitor because fluctuations could change the payback amount to the lender, as the domestic currency would have to be converted back to the foreign currency to repay the loan abroad. Another important factor the company has to be aware of is the horizontal balance structure. To analyze the horizontal balance structure, a company has to compare its cash flow stream of assets and financing to ensure the liquidity of the investment. They should also consider which type of loan they should obtain and whether they will benefit from having installment-free periods. In this case we assume that PharmaGroup will obtain a serial loan, which is a loan with a fixed installment and where the outstanding debt quickly decreases. A disadvantage of the serial loan is that the payment in the first year is quite high, but decreases over time. An annuity loan is a loan with the same payment every year, which for many companies seem to be more manageable. However a possible drawback is the relative low installment and high interest at the beginning of the loan. A final opportunity regarding financing is a bullet loan, which is a loan without any installment until the final year. This type of loan is quite risky, as the company has to pay the whole installment in the last period. For this investment a serial loan would be good as it decreases interest over time, which is the cost of the loan. However an annuity loan might be more advantageous, because PharmaGroup have to invest a lot of money in R&D at the beginning of the new product’s life cycle, which means that there is a great financial expenditure at the start of the investment. 13) Explain and provide calculations assuming that competitions plays out based on volumes In order to calculate the volumes associated with each company, the Cournot model can be applied. Since we are facing oligopolistic competition with, in this case, only two producers of this product on the market, the Cournot model can be applied. The assumption of the model is that a duopolist takes the quantity of another company as given, meaning that they will not change their output levels given the output chosen by the other. Additionally the Cournot model assumes that companies seek to maximize profits based on their competitors’ decisions.


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Each firm has a reaction function, which is found by equating MR and MC. By symmetry the two reaction functions will portray each other. Through the reaction functions, we can find the optimal quantity, which is shown below.

P = 30000-Q MC = 3000

Adjusted curve:

P = 30000-(Q1+Q2) Solving for TR

TR = P*Q1 TR = (30000-(Q1+Q2))*Q1 TR = 30000Q-Q1

2-Q1*Q2

Calculating MR by taking the derivative of TR MR = 30000-2Q1-Q2

Solving π by setting MR=MC

30000-2Q1-Q2 = 3000 30000-3000-Q2 = 2Q1

27000-Q2 = 2Q1

13500 – !!! = Q1

Q1 = 13500 - !!!

This gives us the two reaction functions

Q1 = 13500 - !!Q2

Q2 = 13500 - !!Q1

Putting Q2 into Q1

Q1 = 13500 - !!(13500 - !

!Q1)

Q1 = 13500 – 6750+ !!Q1

Q1 = 6750 + !!Q1

!!Q1 = 6750


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Q1 = 9000 And the total quantity we get is

Q1 + Q2 = 18000

Inserting our result in our demand function P=30000-Q

P=30000-18000 P=12000

Total revenue

Q=12000*9000=108.000.000

14) Explain and provide calculations assuming that competition plays out based on prices In order to calculate the prices associated with each company, the Bertrand model can be applied. We are still facing the same oligopolistic market as in question 13. The assumption of the model is that a firm takes the price of another firm as given, meaning that they will continue charging their current prices. The Bertrand model is more interesting from the buyer’s perspective, as a buyer will be interested in seeing how prices from the two firms compare. According to Bertrand model the firms will keep competing until P=MC

MC = P = 3000 P = 30000 – Q

Inserting the price in the demand and solving for Q

3000 = 30000-Q Q = 30000-300

Q = 27000 Q = Q1 + Q2

Q1 = 13500 = Q2

The TR function

TR= P*Q TR = 3000*13500 TR = 405.00.000

TR = TC

As firms in Bertrand competition keeps competing until P=MC, the profit will eventually become 0.


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15) What can you say about the pay-off matrix and the most rational decision seen from PharmaGroup’s perspective? Strategic behavior describes how competitors in an oligopolistic market reacts according to each other; as there are only two players in the market, the action of each competitor affects the other competitor and its chosen strategy. Therefore each competitor seeks to maximize its profit through adjusting variables such as the level of advertising, quantity of products sold, and the price of the product according to the others. Strategic behavior is often associated with game theory. Game theory views each company as players in a game, and the actions of the companies are viewed as strategic decisions the players make to gain advantage over the other, the opponent company. This can be illustrated through a pay-off matrix where the pay-off is the outcome or consequence of each strategic move the players make. In the given pay-off matrix one can see that PharmaGroup has the option to choose between high or low prices; as PharmaGroup will wish to maximize their profit, they will choose to have low prices and assume that the competitor will choose high prices for their products. By doing so, they will gain 1000, while the competitor will lose 500. However, the competitor will not be satisfied with the prospects of losing 500; as response to the given situation they will choose to lower their prices to match the prices of PharmaGroup. The result will be that both companies will have low prices and thereby each gain 100. When looking at the choice of strategy from the point of view of the competitor, the pay-off matrix will have the same outcome, as both of the players have a dominant strategy. What is characteristic regarding the actions of the companies in the pay-off matrix is that both PharmaGroup and the competitor follow the dominant strategy of having low prices; regardless of what the competitor will choose, both companies will always choose to have low prices, as they both will gain the largest profit from this strategy. The final equilibrium will therefore be that both PharmaGroup and the competitor have low prices, with the result of each gaining 100. This can also be referred to as Nash equilibrium, as it reflects how each player chooses their optimal strategy based on the strategy chosen by the other player. PharmaGroup’s choice of low prices is based on the assumption that the competitor will choose high prices and thereby give PharmaGroup the highest gain; however the competitor will follow the same strategy to maximize their gains and therefore choose to have low prices as well; as a result, none of the companies will enjoy the highest possible gain. The dilemma the companies face is called the prisoners’ dilemma; when competing for the highest profit the oligopolistic companies doesn’t end up choosing the strategy, which yields the highest possible gain; instead they both settle for a strategy with a lower gain. The final equilibrium shows that both PharmaGroup and the competitor will settle for a strategy with low prices and a gain of 100; however, if the companies cooperated, they would both choose high prices and thereby both have a gain of 500. But because they are competitors, the two companies do not trust each other. It is too risky for one company to choose high prices, as the competitor most likely will choose low prices to maximize their gain. If PharmaGroup chooses high prices, and the competitor chooses low prices, the


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competitor would gain 1000 while PharmaGroup would lose 500. As this is an unbeneficial outcome for PharmaGroup, none of the companies will risk it. The end result is that the players will not cooperate and therefore settle for the strategy, which yields the lower gain of 100, instead of risking a failed cooperation and the loss of 500. 16) Would your above conclusions change if the situation is viewed as a repeated game? Repeated games are characterized by a series of moves made by each of the two players in the game. These types of games are more realistic to occur in the real world, as they involve the companies deciding on and possibly changing their business strategies multiple times over the lifespan of the company. Tit-for-tat behavior is a sequential game in where the actions of each player will have influence on the other player’s next move. Consequently, each player will benefit from cooperating as the players will be able to punish each other for betrayal with the outcome of their next move; the tit-for-tat behavior therefore disincline noncooperation. However, there are a series of conditions, which must be fulfilled in order for the players to play this type of repeated game; there should be a limited number of players in the game, as each competitor should be able to keep track of one another’s actions, and immediately discover any kind of disloyalty. The players in the game must be stable to form cooperation with each other, and so must the demand and condition costs, as it otherwise can be difficult to define cooperational behavior. Lastly, it is important to assume that the game is being played an uncertain amount of times, as a game with a certain amount of rounds will end with the players betraying each other in the final rounds. The market for pharmaceutical solutions for the treatment of movement disorders in which PharmaGroup and its competitor operate in, is assumed to be an oligopolistic market, which has relatively predictable market conditions. Therefore the companies have two strategic options within the tit-for-tat behavioral game; they can choose to cooperate and thereby each maximizes their gain by choosing to maintain high prices, which they continuously choose to raise. The effect of such cooperation would result in a different equilibrium outcome, where PharmaGroup and the competitor would each gain 500. However, there is still a risk that the companies are reluctant to cooperate with each other. In that case the competitors would attempt to undercut each other by continuously lowering their prices to gain costumers or end a potential cooperation by betraying each other and thereby gain a temporary lead. If the companies fail to cooperate and act according to the tit-for-tat behavioral game strategies, the equilibrium outcome will remain the same as in the previous question so the gain and equilibrium outcome of each company will remain 100. 17) Could and should PharmaGroup do anything to deter/influence the competitor’s decision? PharmaGroup could carry out strategic moves that would influence and benefit their reputation in the long run with the intention of deter or influence the competitor’s decisions. It would be beneficial for PharmaGroup to establish a reputation as a company that realizes the threats they put forward; in order to obtain such a reputation it is crucial that the company is consistent and


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even implement threats which will result in lower or even zero profit for the company. As such the company should threaten to lower their prices, as it would impose great losses on the competitor from the beginning. By doing so, PharmaGroup would intimidate a possible new competitor and thereby keep them off the market, as companies will choose to stay out of a market that indicates no prospects of financial gain. Another way to keep a competitive company from entering the market is for PharmaGroup to actually realize the threat of lowering the prices; for PharmaGroup to lower their prices, they would need to build up excess capacity. This would allow them to lower their prices. The decrease in price would lead PharmaGroup to gain lesser profit than before, but as it is still profitable for the company to stay in the market, the lower prices would strengthen their position. The low product prices would make it difficult for a new competitor to enter the market as the high entry barriers, which include great investments in e.g. R&D, would make financial gain for a new competitor unlikely and difficult to derive. Thus keeping a possible new competitor off the market. However PharmaGroup would instead wish to influence the decisions of the competitor; thus the credible reputation previously described remains significant for the company. However, when the reputation is established, they can use it to pressure the competitor and thereby affect its actions. PharmaGroup could adapt the role as price leader; if the company announces higher prices, the competitor would follow and also increase their prices, resulting in both companies benefitting from the change in price by gaining 500 each and thereby reaching new outcome equilibrium in the pay-off matrix. This would benefit both companies. Keeping competitors off the market can be rather difficult and risky, as lowering prices may not be sufficient enough to keep strong and financially strong competitors off the market. Instead PharmaGroup would risk loosing a great deal of profit, making it economically unbeneficial for them to operate in the market. They would therefore gain more if they instead try to influence the decisions if their competitor by uing their reputation to cooperate with the competitor, and thereby ensuring higher prices and more profit for both parties. One can assume that the differentiated quality product PharmaGroup offers will be strategically beneficial and advantageous for their reputation and status; therefore it will allow them to gain a high market share and become the key company in the market of pharmaceutical solutions for the treatment of movement disorders. 18) Would you suggest PharmaGroup to consider 2nd degree price differentiation? Price discrimination refers to the practice of charging different prices for different quantities of products at different times or to different costumer groups without the price difference being justified by differences in cost. If PharmaGroup chose to practice 2nd price discrimination it would mean that they would charge an identical price for each pharmaceutical product sold and then charge a lower price for any additional units sold - i.e. offering a quantity discount which would encourage the consumer to purchase more of PharmaGroup’s product. However, this type of discounting is often associated with the strategy of telephone companies, water suppliers, electricity suppliers etc. who all offers services and products


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where the customers consume more when purchasing greater amounts. Nevertheless, in the market where PharmaGroup operates, customers only need a specific amount of the pharmaceutical products which they offer and therefore they wouldn’t increase their purchases if there is offered a quantity discount such as the principle in the 2nd price discrimination. Therefore PharmaGroup wouldn’t benefit from practicing 2nd degree price discrimination. The consumers of the medical products PharmaGroup offers, need to acquire a certain amount of the product despite the cost and would therefore purchase it regardless of any prospects of discount. Because it is a specialized product PharmaGroup offers, consumers such as hospitals wouldn’t purchase more because they only need a specific amount to satisfy the need of their patients. 19. Illustrate the data in a relevant way and comment on the data It is assumed that we are in the short run since capital is fixed; our variable input is labor. The Total Product of Labor indicates how much we can produce with different amounts of labor. Average Product of Labor is the total product divided by the quantity of labor used, found by the mathematical formula: APL= TP/L. Marginal Product is defined as the change in Total Product per unit change in Labor.

It can graphically be seen that MPL is at its highest when 4 sales people are used. Hereafter MPL starts to decline, which occurs because Total Product increases at a decreasing rate. This is a reflection of the law of diminishing returns, which states that when one input is fixed, workers only have a given amount of capital to work with, so the employment of extra workers will start to become less efficient after the maximum MPL is reached. However, it is important to note that MPL continues to stay positive, meaning that Total Product does not decline in this case, shown in the graph. We can define three stages of production; the first stage ranges from the origin to the intersection of the APL and MPL curves. The second stage of production ranges from the maximum APL to where MPL hits zero. Stage three begins when MPL is negative. In relation to this particular graph, stage one starts at the origin and ends at L=7, when the MPL intersects APL from above. At that point stage two begins and as shown it doesn’t end on this graph, since MPL never intersects the x-axis with the numbers we have been given. This also means that we never enter stage three.


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20. Can you say anything about the optimal number of sales people to employ? The optimal number of sales people to employ can be found somewhere in stage two, where MPL is positive but declining. In the graph above it was found that the optimal number is from the 7th sales person and “onwards” even though we are not given any additional numbers. The optimal use of sales people would theoretically be where Marginal Revenue Product of Labor equals the Marginal Resource Cost of Labor. However, since we do not have any information regarding the costs, we are unable to estimate at what point MRC = MRP. Nevertheless, we do know that production should take place somewhere in stage two, as this is where the rational producer would choose to produce. Since stage two begins where MPL intersects APL from above, the only opportunity we have to operate in stage two is at labor = 7. Therefore the optimal number of sales people to employ is found to be seven. 21. What is your analysis of the present production set-up and would you suggest changes? The question deals with finding the optimal combination of respectively labour and capital. Since both input factors are variable this production set-up is associated with the long run. The optimal combination of inputs that maximizes production or minimizes costs can be found at the point where the isoquant is tangent to the isocost line. The isocost line is equal to the ratio of wages and rent and shows the combination of input that yields the same cost, whilst an isoquant shows all possible


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combinations of capital and labour that result in the same amount of output. The slope of an isoquant is defined as the Marginal Rate of Substitution. MRTS is found by dividing the marginal product of labour with the marginal product of capital:

line, which is given by: 𝐶 = 𝑤𝐿 + 𝑟𝐾, and MRTS has to be equal to the isocost by isolating K, the equation will be rewritten as 𝐾 = !

!− !

!𝐿. When having isolated K, the slope can be

identified as –!!.

Since we know that the MRTS has to be equal to the slope of the isocost line, the optimality condition is written as: !"!

!"!= !

!

MPL is in this case equal to 70, while MPK is equal to 20. Wages are €3000 and the price of capital (r) is €1000. Plotting these values into the condition for the optimal combination of input we get: The optimal condition is thus not upheld, since MRTS is not equal to the slope of the isocost line.

Because we assume that wages and price of capital are fixed, PharmaGroup must change either their use of Labour or Capital, so the MRTS associated with the new point on the isoquant will equal the slope of the isocost line. In other words, the isoquant will then be tangent to the isocost line. 22. How can you illustrate this and what does it tell you about economies of scale for this production? Economies of scale describes the degree of output changes due to a given change in the quantities of inputs used. Returns to scale can either be constant, increasing, or decreasing. If output increases in the same proportion as inputs, we have constant returns to scale. If output on the other hand increases in a greater proportion then the increase in inputs, we experience increasing returns to scale. Decreasing returns to scale is when output increases by a smaller proportion than inputs. In this case, PharmaGroup’s production facility had a use of K = 1000 and L = 12 in the first production process, where they produced 2000 units of output. Now, a further investment in capital and employees has resulted in an increase in inputs to K = 3000 and L = 36 in order to produce 9000 units of output. Graphically, we reach a new isoquant, which is placed further to the right of the previous isoquant. It shows how a higher amount of output has been reached, and can be seen illustrated in the following graph:


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It is evident that both inputs have been multiplied by 3, since: 3000/1000 = 3 and 36/12 = 3 However, output is multiplied by 4,5. In other words, output increases by a larger proportion than inputs, which means that this further investment in capital and employees exhibits increasing returns to scale. 23. What is “economies of scope” and what could be examples of this for

PharmaGroup according to you? Economies of scope is similar to economies of scale, but focuses instead on the coalition of two or more products rather than the production of just one specific product. When a greater variety of products are produced by a given company, the Average Total Cost of Production will be lower than if these products were made by independent companies. This is because some of the machines used at the production facilities can aid in the production of more than just one product. In order for PharmaGroup to take advantage of economies of scope they should extend their product line. This could be done through either producing different products, or through products that are interrelated such that the original product becomes more desirable when combined with other products offered by PharmaGroup. If PharmaGroup offered more products similar to, for instance, the new Xiquinon product they could save money on production and R&D, since these processes could be made simultaneously. As we know that PharmaGroup sells their products in Europe, North America, China, and India, economies of scope would also save them transportation costs, when combining the transportation of different products from their production line.


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Bibliography

• Castner, M., Hayes, J. & Shankle. (2007) The global pharmaceutical Industry. International

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• BBC UK. 2014. Experimenting on animals. Retrieved May 5, 2014.

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Retrived April 5, 2014 from

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superstition%20and%20black%20magic%20ordinance

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Drinkard, Jim. (2005, April). Drugmakers go furthest to sway Congress. USA to Day.


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Appendix 1

Business Evaluation


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Appendix 2 Best Case Worst Case


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Appendix 3

Documents

The$case$of$$ PharmaGroup$ - IBP · pharmaceutical products, ... industry has several different suppliers for the necessities required to produce their products, for instance