Problem
The following excerpt is from Note 3 of Merck and Co., Inc.'s financial statements included in the company's December 31, 2017 SEC Form 10-K:
In July 2016, Merck acquired Afferent Pharmaceuticals (Afferent), a privately held pharmaceutical company focused on the development of therapeutic candidates targeting the P2X3 receptor for the treatment of common, poorly-managed, neurogenic conditions. Afferent's lead investigational candi- date, MK-7264 (formerly AF-219), is a selective, non-narcotic, orally-administered P2X3 antagonist being evaluated for the treatment of refractory, chronic cough. Total consideration transferred of $510 million included cash paid for outstanding Afferent shares of $487 million, as well as share-based com- pensation payments to settle equity awards attributable to precombination service and cash paid for transaction costs on behalf of Afferent. In addition, former Afferent shareholders are eligible to receive a total of up to an additional $750 million contingent upon the attainment of certain clinical develop- ment and commercial milestones for multiple indications and candidates, including MK-7264. This transaction was accounted for as an acquisition of a business. The Company determined the fair value of the contingent consideration was $223 million at the acquisition date utilizing a probability-weighted estimated cash flow stream using an appropriate discount rate dependent on the nature and timing of the milestone payment. Merck recognized an intangible asset for IPR&D of $832 million, net deferred tax liabilities of $258 million, and other net assets of $29 million (primarily consisting of cash acquired). The excess of the consideration transferred over the fair value of net assets acquired of $130 million was recorded as goodwill that was allocated to the Pharmaceutical segment and is not deductible for tax purposes. The fair value of the identifiable intangible asset related to IPR&D was determined using an income approach. The asset's probability-adjusted future net cash flows were discounted to present value using a discount rate of 11.5%. Actual cash flows are likely to be different than those assumed.
1) Describe the valuation approach that Merck used for the contingent consideration and IPR&D related to the Afferent acquisition.
2) How much subjectivity is involved in each valuation method? What kind of assumptions need to be made under each approach?
3) What are the total possible contingent payments for achievement of "clinical development and commercial milestones" related to the Afferent acquisition? What is the acquisition-date fair value of these potential future payments? Why did the Afferent transaction include these contingent (future) payments instead of cash consideration equal to the contingent-payment acquisition-date fair value?
4) Assume, on June 30, 2017, Merck is required to make all contingent payments related to the Afferent acquisition (i.e., the contingency is resolved in favor of the seller). Also assume the fair value of the contingent consideration at the most recent financial statement date (i.e., March 31, 2017) was equal to its acquisition date fair value. Provide the journal entry related to the contingent payments that Merck will make on June 30, 2017.