application of real options valuation to r&d investments in ...

APPLICATION OF REAL OPTIONS VALUATIONTO R&D INVESTMENTSIN PHARMACEUTICAL COMPANIESBYHUAN RAN ZHANG2006A dissertation presented in part consideration for the degree of‘MA in Finance and Investment’

AbstractThis paper provides an insight into the application of real option valuation method toR&D projects in pharmaceutical companies.As one of the most important corporate finance decision-making methods, real optionvaluation method has been introduced in the last two decades. By applying optionvaluation methods, real option valuation is a useful tool to company managers. R&Dinvestments in pharmaceutical companies are subject to considerable uncertainty,which may involve possibilities (i.e. Options). Options create value when the future isuncertain, and they support management to draw the highest possible value from aninvestment.After a careful review of the literature, including the definition and types of realoptions, its advantages over traditional valuation method and fundamentals of optionpricing model, the general application of these theories to R&D investments inpharmaceutical industry is analysed. A case study of Davanrik at Merck & Co. isintroduced to illustrate a situation in a real world context.Several option pricing methods can be used for a real options valuation, but binomialtrees valuation method is chosen, as it could be more suitable model for valuinginvestment with high uncertainty, like pharmaceutical R&D s, especially for thiscomplex compound rainbow option. The use of two different valuation methodsprovides two different option values, which shows the importance of choosing acorrect valuation method. In all, the use of real option valuation approach couldincrease the value of pharmaceutical R&D investment, and the binomial treesapproach is capable for valuing investments with high uncertainty like in this context.i

Table of ContentsAbstract .................................................................................................................... iTable of Contents ..................................................................................................... iiList of Tables ........................................................................................................... ivList of Figures .......................................................................................................... vChapter One— Introduction ................................................................................... 1Chapter Two— Literature Review ......................................................................... 42.1 Concept of Real Options .................................................................................. 42.1.1 Definitions of Real Options ........................................................................ 42.1.2 Types of Real Options ................................................................................ 52.2 Advantages of Real Option Valuation over other valuation methods ................ 112.2.1. Benefits of real options valuation method................................................. 112.2.2 Advantages over NPV .............................................................................. 132.2.3 Advantages over decision trees method .................................................... 152.3 Option Pricing Theory .................................................................................... 172.3.1 Fundamentals: call, put ............................................................................ 172.3.2 Five variables that determine the value of an option ................................. 182.3.3 Risk-neutral valuation .............................................................................. 192.3.4 Option pricing models .............................................................................. 202.3.4.1 Introduction ..................................................................................................202.3.4.2 Binomial Trees Model ..................................................................................212.3.4.3 Black and Scholes Model ..............................................................................212.3.5 Compound Option.................................................................................... 232.3.6 Monte Carlo Simulation ........................................................................... 232.3.7 Asset Behaviour ....................................................................................... 242.4 Brief summary ............................................................................................... 24Chapter Three— Apply Real options evaluation to R&D projects inpharmaceutical companies .................................................................................... 253.1 Typical drug development process .................................................................. 253.1.1 Preclinical Testing .................................................................................... 273.1.2 Phase I Clinical Trials .............................................................................. 27ii

3.1.3 Phase II Clinical Trials ............................................................................. 273.1.4 Phase III Clinical Trials ............................................................................ 283.1.5 FDA approval .......................................................................................... 283.2 real options valuation in pharmaceutical industry ........................................... 293.2.1 Introduction ............................................................................................. 293.2.2 Five variables that determine the value of financial options –analogies toreal R&D options in pharmaceutical companies ................................................ 323.3 Brief summary ............................................................................................... 36Chapter Four— Case Study ....................................................................................374.1 Introduction.................................................................................................... 374.2 Merck Company ............................................................................................. 384.3 Davanrik ........................................................................................................ 394.4 D avanrik’s P otential C ash flow s ..................................................................... 40Phase I .............................................................................................................. 40Phase II ............................................................................................................ 40Phase III ........................................................................................................... 41Chapter Five— Case Study Analysis ......................................................................435.1 NPV ............................................................................................................... 435.2 Option B (Year 7 to year 17) .......................................................................... 465.2.1 Five variables that determine the value of the options .............................. 465.2.2 Valuation of the abandonment option (Option B) ...................................... 485.3 Option A (Year 0 to year 7) ............................................................................. 525.3.1 Five variables that determine the value of the options .............................. 535.3.2 Valuation of the compound option A using simple valuation method ........ 575.3.4 Valuation of the compound option –compound rainbow option ................ 635.4 Sensitivity Analysis and comparison of two methods ...................................... 65Chapter Six— Limitations and conclusion .............................................................676.1 limitations ...................................................................................................... 676.1.1 For Option B ............................................................................................ 676.1.2 For Option A ............................................................................................ 686.2 Conclusion ..................................................................................................... 68References ...............................................................................................................71iii

List of TablesTable 5.1: Value of Option B ....................................................................................52Table 5.2: Time value of investment cost ..................................................................55Table 5.3: Exercise Price of Option A (Year 0-7) ......................................................56Table 5.4 ENPV .......................................................................................................62Table 5.5: Calculation for option value with different volatility ................................64iv

List of FiguresFigure 2.1: Comparison of three project valuation methods using decision trees .... 16Figure 2.2: Advantages and disadvantages of the three methods that use decisiontrees for dynamic cash flow analysis ..................................................................... 17Figure 3.1: Stages in Drug Development of a typical project 1 .............................. 26Figure 3.2: Stages in Drug Development of a typical project 2 .............................. 26Figure 3.3: Comparison of a call option with an investment a new production plant............................................................................................................................. 31Figure 3.4: analogies between stock options and real options in R&D project........ 32Figure 5.1: R&D Process of Davanrik at Merck & Co. .......................................... 43Figure 5.2: NPV of Davanrik at Merck & Co. 1..................................................... 44Figure 5.3: NPV of Davanrik at Merck & Co. 2..................................................... 45Figure 5.4: Volatility estimation for option from year7 to year 17 .......................... 48Figure 5.5: Valuation of Option B (underlying: Depression) .................................. 49Figure 5.6: Valuation of Option B (underlying: Weight loss) ................................. 50Figure 5.7: Valuation of Option B (underlying: Both) ............................................ 51Figure 5.8: Volatility of Option A (Year 0-7 ........................................................... 54Figure 5.9: new flow chart of the Davanrik R&D process (real time value) ........... 57Figure 5.10: Valuation of Option A (underlying: Depression) ................................ 59Figure 5.11: Valuation of Option A (underlying: Weight Loss)............................... 60Figure 5.12: Valuation of Option A (underlying: Both) .......................................... 61Figure 5.13: Valuation of Compound rainbow option ............................................ 63Figure 5.14: Sensitivity Analysis for two valuation methods.................................. 65v

Chapter One— IntroductionAs one of the most important corporate finance decision-making methods, real optionvaluation method has been introduced in the last two decades. By applying optionvaluation methods, real option valuation is a useful tool to company managers.M anagers o f firm s m ay not necessarily use the term ―real options‖ to describe theseopportunities, they m ay use the term ―strategic value‖ or ―intangible advantages‖, andthese sometimes become the key in their decision-making process.This paper is the application of real option valuation method to R&D projects inpharmaceutical companies. This paper is motivated by the need of more accuratevaluations for high intensive Research and Development (R&D) projects. An accurateproject valuation is crucial for the survival of companies. Especially for those sectorsthat have R&D intensive projects with high uncertainty, being able to compute a goodapproximation of the value of the project is critical for the decision-making process.The fact that managers can decide what action to take at different points during thelife of the project has proven to be quite valuable. The value of these options can besuch that makes the difference between entering or not in an investment. The RealOptions Approach attempts to value projects by considering the value of being able todecide among several strategic options. Especially when the value of a project ishighly dependent on the level of flexibility that it allows, the real option methodologyshould be used. Otherwise, the valuation is not accurate because the project isundervalued.Page | 1

Several option-pricing methods can be used for a real options valuation. However, thecomplexity of real world projects makes some of these models not flexible enough toconsider all its features.Binomial trees valuation method appears to be one of the more flexible option pricingmodels and probably a more suitable model for valuing investment with highuncertainty, like R&D projects, comparing to options pricing models likeBlack-Scholes valuation model.The main objective of this paper is to critically review the use of the binomial treesvaluation method for valuing R&D projects in Pharmaceuticals companies. The paperis going to explore the question that whether the real options valuation method canprovide an adequate valuation approach to R&D investment, in the context ofpharmaceutical companies; and whether the binomial trees approach is capable forvaluing investments with high uncertainty like pharmaceutical R&D? A case studymethodology is used to address the above-mentioned questions.In chapter 2, a review of the literature is presented, which start with the definition andtypes of real options, the advantages of real option valuation approach over traditionalvaluation method, followed by the fundamentals of option pricing model, includingfive variables that determines the value of an option, option pricing models andrisk-neutral valuation.Chapter 3 focus on the application of real options valuation method to R&D projectsin pharmaceutical companies. It starts with the review of typical drug developmentprocess, and followed by the analogies of valuation model to real options of R&Dprojects in pharmaceutical companies. The analogies of the five variables thatdetermine the value of an option to real R&D options are discussed in detail.Page | 2

Then, in Chapter 4, the case study is introduced. It is a case that a few overseasuniversities have referred to when introducing the concept of net present value.Chapter 5 presents the valuation of real options realized in the case by using thebinomial trees.Finally in Chapter 6, conclusion is presented together with the limitations.Page | 3

Chapter Two— Literature ReviewThe objective of this chapter is to introduce the concept of real options and Realoption valuation method. Firstly, the definition and types of real options are presentd,which is followed by the advantages of real option valuation approach over traditionalvaluation method. Next, fundamentals of option pricing model is explored, includingfive variables that determine the value of an option, option pricing models andrisk-neutral valuation and Monte Carlo simulation.2.1 Concept of Real Options2.1.1 Definitions of Real OptionsAn option is the right, but not the obligation, to take an action in the future (Dixit andPindyck, 1995). Options have value when the future is uncertain. The higher theuncertainty related to the value of the stock, the higher is the opportunity that thestock price at that day will actually exceed the exercise price by a significant amount.However, if the value of the stock is below the exercise price, there will be noobligation to exercise the option.The real options approach is an extension of financial option theory to non-financialassets. While options on financial assets are clearly defined in the option contract, realoptions are embedded in strategy and tactics or, in other words, in the corporate visionand in project and portfolio management. A real option exists if we have the right totake a decision at one or more points in the future (e.g. to invest or not to invest, or tosell out or not to sell out). Between now and the time of decision, market conditionswill change unpredictably, making one or other of the available decisions better for us,Page | 4

and we will have the right to take whatever decision will suit us best at the time,defined by Newton and Paxson (2001).2.1.2 Types of Real OptionsThere are different types of real options, and the most common options are: options todefer, options to expand, options to abandon, options to switch. Like options, thevalue of the real option can be derived from Black-Scholes Formula or Binomial Treemethod if it is a European Option, but for American options, it can be calculated byBinomial Tree method only.The option to expand/contract capacity:C om panies often cite ―strategic‖ value w hen taking on negative N P V projects. T hat is,today‘s investm ents can generate tom orrow ‘s opportunities. T he option to exp and issimilar to a call option. And assume the project can be expanded by x% with a cost ofI E , then I E would be the exercise price, and the present value of future cash flow, V,would be the value of the underlying asset.Options similar to this type can also be options to reduce operating scale or eventemporarily shut down facilities. When applying these types of real options to thepharmaceutical industry, for example, the demand for certain drugs may vary due toseasonal differences. The options to expand or reduce operating scale would beespecially relevant if it were impossible or disadvantageous to store the product forsome time, thus making a constant production rate unfeasible. Furthermore, R&Dfacilities (such as an automated screening laboratory) may only be requiredtemporarily. If the cost of closing and re-opening is acceptable and technicallypossible, it may be a good decision to shut down the facility temporarily and free upresources for other applications, suggested by Bode-Greuel (2000)The report by Bode-Greuel (2000) also suggests that in ―know how‖- intensivebusinesses, such as the pharmaceutical industry, adapting operating scale could alsoPage | 5

mean that a company is temporarily reducing capacity in a certain business areabecause conditions have developed unfavorably. For example, a company mightdecide to reduce in-house research capacity in neurodegenerative diseases, becausethe results obtained so far have been disappointing in relation to the resources that hadbeen invested. Instead, research is continued at a lower funding level by co-operatingwith universities. However, the company would like to retain the option of expandingin-house activities when promising results emerge from university research.―Know how‖-intensive industries face the challenge that temporarily reducingcapacity does not only mean closing facilities, but also not using their employees‘expertise property. Scientists specialized in neurodegenerative diseases cannot betemporarily assigned other research projects, because acquitting expertise in anotherarea take time. Furthermore, they may become frustrated and leave the company,leading to a drain of expertise. The number of employees working in a productionfacility can be adapted more easily to changing demands, than the number of expertsworking in a certain business area. Expert knowledge and long-term commitment ofexperts to their company are valuable assets that should be traded off against thebenefit of adapting operating scale in R&D.In summary, the option to adapt operating scale is not as readily applicable toR&D-intensive industries as it is to businesses whose profitability predominantlydepends on the optimal adaptation to volatile market prices. Rather, R&D requires along-term strategic orientation in order to build up the required capabilities and attracthigh-level experts. This also applies to small and medium =sized companies, whichoutsource many of their technical operations.The option to abandon:The option to abandon a project provides partial insurance against failure, as once theproject is no longer profitable, the company can exercise this option to abandon thePage | 6

project, to get its salvage value, A , w hich is the value of the project‘s assets if so ld orshifted to a more valuable use. The option to abandon is a put option, and the exerciseprice is the salvage value, A.It is possible that, during development, managers realize that the market for a productdevelops unfavorably. A newly-launched medicine may weaken the competitiveposition of the product in development, or health political decisions may affect theprofitability of the compound such that it no longer deserves priority compared to theother development compounds of the portfolio. In this case, management may decideto cancel development in order to free resources for more promising projectcandidates; alternatively, the project may be out licensed, thereby creating a salvagevalue. Furthermore, there may be project-specific assets, such as technical equipment,that can be sold on the second-hand market. Nevertheless, abandonment should not beexercised lightly; it might lead to an erosion of valuable expertise or organizationalcapabilities that could be applied to forthcoming projects (Bode-Greuel, 1997).The most relevant abandonment option in pharmaceutical R&D is the necessity toterminate a project because the results of R&D activities did not meet management‘sexpectations. A research concept may simply not work out. In development, there aremany critical milestones that need to be achieved, and the majority of projectsentering development have to be abandoned at a certain stage. If failure is the reasonfor abandonment, there is no tangible salvage value. The value of the option is relatedto the fact that further investments are saved. Furthermore, valuable expertise mayhave been obtained, to the benefit of other forthcoming projects.Modeled abandonment options in decision trees enable management to investigate indetail the risk structure of a project, and take actions to increase the value of a project.For example, completing risky studies early rather than late will create value, becausethe chances of abandoning the project before high costs have occurred are increased.Page | 7

In financial terms, an abandonment option can be considered as a put option on aproject‘s current value (however, when a project fails, there is usually not salvagevalue, and the underlying asset is worthless. In this case, the put option is alsoworthless).The option to defer (wait):It is the right to postpone an investment in order to benefit from the resolution ofuncertainty. Even when a project has a positive net present value (NPV) which wouldsuggest an im m ediate ‗go‘ decisio n, it m ay create m ore value to w ait and invest inactivities that provide critical information before going ahead with the project.In the pharmaceutical industry, R&D management is generally focused on completingprojects quickly in order to exploit patent protection in the best possible way(Bode-Greuel, 1997). However, this may not always have priority in the presence ofuncertainty. Even if the expected NPV of a project is positive, it is not necessarily thebest decision to proceed immediately with the next investment. It may create value towait for more information when risk can be reduced, either by waiting to see whetherexternal conditions develop favorably, or by undertaking studies that generate criticalinformation.However, in the pharmaceutical industry, waiting passively is only appropriate whenexternal factors (factors that cannot be influenced by the company), such ascommercial or health political risks, are the source of the risk (Bode-Breuel, 1997).Uncertainties related to R&D are usually best resolved by actively generating thecritical information. If a company was to wait passively for pharmacological ortechnical risks to be resolved by external research institutes or competitors, it wouldloose the opportunity of patent protection and would thus weaken its competitionposition.Page | 8

The option to switch:If assets have more than one application, the option to switch among the possibleapplications will support flexibility and will thereby create value.The option to improve:This type of real option is suggested by Huchzermeier and Loch (1998) as a specialtype of R&D, rather than a type according to common classification of real options.This option occurs where management has the opportunity of taking corrective actionduring the course of a project. For example, the project target profile that outlines thegoals of a project with respect to the desired product properties can be adapted tochanging market conditions.Furthermore, management can adapt the clinical development plan to changedregulatory guidelines. Clinical development can be redefined to accentuate acom pound‘s efficacy profile based on information obtained in previous clinicalstudies (Bode-Breuel, 1997). Thus, the option to improve is relevant for assets that arecharacterized by significant technical risks whose resolution strongly determines themarket value of the asset.The option to improve is an additional source of value, because it helps to exploit theupside potential of uncertainty. The flexibility to adapt development plans on the basisof learning creates value by revealing the best possible product profile. When projectsare re-evaluated after achieving the next milestone, managers may not only considerto continue as planned, or cancel the project when results prove unfavourable.Strategic or growth options:These are opportunities arising in the future by undertaking projects, but are notconstituent of the initial project. Since they pave the way for future growth of thePage | 9

company, they have a high strategic value (Bode-Breuel, 1997).Growth options are a typical feature of R&D-intensive and technology-basedindustries. Investments in research projects are prerequisites for follow-up projectsthat finally lead to a marketable product. Managers sometimes decide to invest in thedevelopment of a product that, when evaluated alone, does not have a high NPV. Byinvesting in an innovative first-generation product, managers expect that theinfrastructure, experience and knowledge gained will create the basis fro developinghigher-quality and lower-cost follow-up products that will also have higher NPVs. Inaddition, unanticipated applications or by-products may emerge, creating additionalvalue.Accepting risk is an important prerequisite for growth based on innovation.Companies that are too risk-averse destroy their innovative potential and potentiallylose their competitive position. The challenge is to build decisions on a systematicanalysis of project proposals, and on the assumed growth options that projects maycreate. Scientific intuition and passion are necessary prerequisites for analyzing thestrategic value of pharmaceutical R&D projects. Scientists, on the basis of theirexperience and knowledge, are able to develop a vision of follow-up opportunitiesthat may result from a project.Nevertheless, scientific brilliance is not enough. In evaluating the value of marketableassets that could ―grow‖ on a project under consideration, marketing expert arecontributing market models by assessing potential market size, market and sales risks,and product price volatility. Analysts are needed to create financial models thatcapture the option value of R&D projects. In the chapters later, it will be discussedhow appropriate models may be designed. Based on such systematic, interdisciplinaryapproach, management will be in a better position to prioritize projects.Page | 10

2.2 Advantages of Real Option Valuation over other valuationmethods2.2.1. Benefits of real options valuation methodAccording to the report by Technopolis Limited (2005), real options valuationapproach can capture the financial value of the R&D portfolio more accurately, as aresult of the realization of the value of flexibility. And the advantages of real optionsvaluation approach can be as follows:Firstly, according to the characteristics of R&D projects, they are contingent decisionsthat depend on the sequential steps in the future. Investing in the next R&D milestonecan be regarded as investing in a call option on the forthcoming milestone. ResearchProject investment can be considered call options on drug development candidates.Also, outlicensing opportunities can be considered put options. The real optionsthinking are very important for management in evaluating investment opportunitieswith respect to projects‘ valuable contingent claims. In the case of R&D projects,these contingent investment decisions create value for a company since the financialloss is limited only to a small portion of project costs. Also, real options thinking helpmanagement in evaluating growth opportunities that are relevant to the research stageof R&D projects.Secondly, according to Trigeorgis (2004), traditional NPV is a simple discounted cashflow model that is used for valuing passive assets, i.e. valuing predetermined cashflow. In contrast, the real options approach is a financial model that adequatelycaptures the value of operating and strategic options. Therefore, using real optionsapproach to asset valuation is regarded as strategic NPV, which is equal to traditionalNPV plus strategic value (Trigeorgis, 2004). In the case of R&D projects andportfolios, the real options approach to appraisal can be used for managing financialimpact in a way that unfavourable outcomes is minimized, while opportunities tocreate value are exploited.Furthermore, the value of managerial flexibility andPage | 11

upside potential of risk are not captured by the conventional NPV.In comparisons,real options evaluation capture the upside potential risk more properly, rather thanreward higher risk at a higher discount rate for cash flow. Therefore, it has beenargued that real options evaluation provided more valid financial results (Technopolis(2005).Thirdly, it is also suggested by Technopolis (2005), that the real options approachoffers a new algorithm for financial project evaluation. This is based on methods usedfor pricing financial options. The value of options traded on capital markets is drivenby market (exogenous) risk.Option value can be determined by using discrete-timemodels such as the binomial trees method and continuous-time models such asBlack-Scholes approach. The Binomial Lattices or trees model can be employed toaccurately price financial options and can produce identical solutions asBlack-Scholes formula (Brandao et al., 2005). The binomial trees model is applicableto early-exercise American financial options, while the Black-Scholes model can beonly used to price options with fixed maturity. Compared with other mainstreammethods such as partial-different equations and closed-form solutions employed inanalyzing real options problems, the binomial approach is favored by managers sinceit is relatively simple in mathematics and it is easily to be explained (Mun, 2002).Another main advantage of using binomial approach is that this method applies theprincipal of risk-neutral valuation (Hull, 2006). In practice it is not easy to obtain theappropriate risk-adjusted discount rate. If we use the risk-neutral valuation principal,the expected cash flow would be discounted at the rate which can be easily obtainedfrom market data (for example, the risk-free rate). Also, the probability of up (p) ordown (1-p) movement is presumed in a risk-neutral world (Hull, 2006). Moreover, thevalue of p and (1-p) are constant and applied throughout the tree or lattice under thecommon assumption of Geometric Brownian Motion with ―constant volatilityregarding the stochastic process associated with the project value‖ (Brandao et al.2005, p.74).Page | 12

In the case of pharmaceutical R&D, the analogy between financial options and realoptions in is more complex. In R&D, risk is not only stemming from market factorsthat are reflected in the predicted volatility of sales. The value of R&D projects is alsostrongly determined by R&D risks. Real options are embedded in a pro ject‘s strategyand tactics, and need to be identified before they can be modeled and evaluatedproperly (Technopolis, 2005).2.2.2 Advantages over NPVThe Net present value (NPV) is calculated as a project‘s expected cash flowsdiscounted at a rate that reflects the risk of those cash flows. Generally, it worthinvesting if the NPV of the project is positive; but if it is negative or zero, the projectshould not be undertaken. The traditional passive (or static) NPV approach has longbeen employed by managers in decision making. This conventional discounted cashflow (DCF) method is still widely used since it is consistent with the objective ofmaximizing shareho lders‘ wealth and it is relatively simple to compute NPV by usingthe risk-adjusted-discounted rate (Trigeorgis, 2002; Brealey and Myers, 2003).However, many researchers recognize the limitations of traditional NPV and otherDCF approaches. Suggested by Newton et al (2004), one of these limitations is animplicit assumption of managerial inflexibility. DCF valuation assumes that a projectwill proceed as planned, regardless of what happen in the future, and precludesoperational flexibilities. Hayes and Garvin (1982), Myers (1987), and Trigeorgis(2002) address that conventional DCF rule tend to undervalue investmentopportunities and fail to recognize the importance of operating flexibility and strategicoptions in a highly uncertain competitive market. To evaluate capital investmentopportunities, managers should have the flexibility (i.e. options) to respond tofavorable or adverse market conditions. In other words, they may ―expand, defer,contract, abandon, or otherwise alter‖ the investment according to market conditions(Trigeorgis, 2004, pg.103). Holding investment opportunities is something like havinga right but not obligation to exercise a call or put financial options. Using optionpricing technique to value these options is known as real options (Hull, 2006).Page | 13

When the traditional Discount Cash Flow (DCF) is used to value a project, it isimplicitly assumed that the firm will hold the project passively. This is an idea thatDCF does not reflect the value of management. Real option valuation method, incontrast, captures the value of flexibility in managerial decision making process at afuture data in response to the arrival of new information (Copeland et al., 2005, p.345),whereas Net Present Value (NPV) and DCF methods do not incorporate with it.Hayes and Garvin (1982) criticized the traditional DCF and NPV by arguing that theymake the implicit assumption that investment processes are reversible, leading tosystematic bias against investment in new capital stock. The reversibility ofinvestment refers to the situation in which if one buys an asset, he can always sell itback later or in which investment can always be delayed without incurring anyadditional cost. The truth is that no company can be sure of recovering lost ground soeasily. What is more, according to Hayes and Garvin, the threat implicit in thediscounting techniques can extend to the misperceptions of uncertainties and themyopia of investment choice. Managers, in their quest to avoid regret, tend to avoidlong-term projects with substantial upside benefits to the firm. Thus, the slowdown inthe long-term capital investments in 1980s can be attributed largely to the failure ofthe DCF analysis.Ross (1995) further claimed that all investment decisions should be treated as optionvaluation problems. Ross states that the NPV rule fails to help investmentdecision-makers in two aspects. First, the NPV rule may reject an investment when itshould be accepted, because most projects are not just a one-time investment ratherincluding the rights to the subsequent investment. Simply because the investment isunprofitable today does not mean that it is worthless forever, at least for the durationof the project. Furthermore, since capital rationing is a given limitation for mostcompanies, each project competes not only with other alternatives but with itselfPage | 14

delayed in time. Undertaking one project may rule out other superior projects anditself at some later data, thus trading off the instant value by exercising the projecttoday against the opportunity of future project gains.But it does not necessarily mean that real options valuation methods can replace NPVor DCF methods. This is because to use real option valuation methods, the value ofthe underlying asset has to be calculated, and DCF is typically used for value that.Moreover, DCF is useful for safe cash flows, where there is less uncertainty. In all,real options valuation method offers a better way of capturing the value of flexibility,and DCF method can be viewed as the base model of real options method when thereis no possibility of calculating of the value of the flexibility of the project, argued byNewton, Paxson and Widdicks (2004).2.2.3 Advantages over decision trees methodThe real options approach offers several advantages over decision trees method.Firstly, although decision trees method is useful for modeling the possible outcomesthat associated with uncertain subsequent activities in a project and evaluate allalternative actions managers can take, the decision trees method is discrete in time(Bode-Greuel, 2000). In contrast, options analysis is continuous.Secondly, decision trees analysis will not give the correct value for options because itis not a risk neutral analysis. As indicated by Bode-Greuel (2000), decision treesmethod is a model of decision makers‘ individual attitude toward risk because theymake subjective judgment which is based on the characteristics of utility function.Although the expected PV of a project is computed by assuming that decision makeris risk-neutral in decision trees analysis, probability is determined by the informationavailable at the time when decision maker doing analysis. This implies that thedecision makers are analyzing projects in accordance with their risk attitudes, i.e. thedegree of risk-seeking or risk-averse. Conversely, real options analysis assumes arisk-neutral world, where probability assessment is not depended on decision makers‘Page | 15

attitudes towards risk and judgment on information available, but is determined by themarket. Bode-Greuel (2000) argues that the risk-neutral principle is particularlyimportant for projects that involve major proportions of the R&D since R&D budge isdiversified over a large number of projects in large companies. Therefore, valuederived from the real options analysis is consistent with a project‘s contribution toshareholder value creation.The figures below demonstrate the differences among DCF, decision trees and realoption valuation with respect to their contribution to decision making.Figure 2.1: Comparison of three project valuation methods using decision trees(Source: Bode-Greuel K. 2000)Page | 16

Figure 2.2: Advantages and disadvantages of the three methods that use decision trees fordynamic cash flow analysis(Source: Bode-Greuel K. 2000)2.3 Option Pricing Theory2.3.1 Fundamentals: call, putCall option - the right to acquire an asset at some future time for a cost which isknow n now , how ever m uch the asset‘s m arket value m ay change m eanw hile.Put option - the right to sell an asset in future, at a price known now, whatever itsmarket selling price may be at that time.European option - option which gives the right to invest (or to sell out) on only onefixed future date.American option - option which gives us the right to invest (or to sell) at any time wechoose, usually up to some fixed final date.In the money- the situation when the current value of the underlying asset is higherPage | 17

than the exercise price.Out of the money – the current value of the underlying asset is lower than the exerciseprice.Exercising the option – the action of buying or selling the underlying asset2.3.2 Five variables that determine the value of an optionExercise price - the known price at which a call (or a put) option allows us to buy (orrespectively to sell) a given asset. For example, an exact quoted price at which wecould install new production equipment (call) or sell off old machinery for scrap (put).It is also known as strike price.Expiry date - the date when an option to invest (call option) or to sell (put option)expires, e.g. for a real option it may be when a patent or licence expires, or when anendorsing athlete retires, or when competitors are expected to catch up with ourtechnology.Stock Price – the price for the underlying asset which is the asset which a real optiongives us the right to buy (call option) or to sell (put option), e.g. a productionoperation or a revenue stream.Volatility — the speed at which the market value of the underlying asset (the assetwhich we hold a real call option to buy, or a put option to sell) tends to the avergerando m ly aw ay fro m (and around) today‘s value as tim e passes into the future. H ighervolatility means a larger expected speed of divergence, giving larger possiblevariations both upside and downside. This increases option value. For example, if wehave a call option (to buy at a fixed exercise price), a larger upside increases the sizeof our largest possible payoff, but the larger downside does not reduce the size of ourPage | 18

smallest possible payoff of zero, which we get if our call option expires unexercised.Risk-free interest rate.2.3.3 Risk-neutral valuationAs indicated above, decision trees method uses the actual probabilities of the pricemovement of the underlying assets. Bode-Creuel (2000) argues that risk-neutralvaluation uses risk-adjusted probability or weighting factors which are derived fromthe market where uncertainty is only characterized by the range of possible futurevalues for the underlying asset that the analyst perceives. Therefore, Bode-Creuel(2000) concludes that weighting factors are not true probabilities. Hull (2006)argues that option pricing does not require the measures of risk aversion since marketvalue of risk is included through the market‘s perception of the asset. In this respect, ithas advantages compared to DCF and decision trees analysis.According to Bode-Creuel (2000), although real options approach to the valuation ofuncertain investment opportunities is very useful, the situation is very complex in thepharmaceutical industry. This is because R&D projects are not traded and thereforethere is no market price for R&D. Furthermore, the value of a project is significantlyaffected by the technical (or private) risk. As an example given by Bode-Creuel(2000), a product which is assumed to result from a specific research project can oftennot yet be characterized; rather, it is ―created‖ during the course of the project, and itsvalue is determined by the way in which technical risks are resolved. Consequently,identifying a security with appropriate market price that is perfect matching is not aneasy issue. However, Trigergis (1996) argues that any contingent claim on an assetcan be priced by applying certainty-equivalent cash flows and the certainty-equivalentdiscount rate. Therefore, for real assets which market-price risk can not be ascertained,such as R&D projects, it has been suggested that risk-neutral valuation is appropriatein the R&D projects (i.e. the risk-free rate should apply in the R&D phase).Page | 19

2.3.4 Option pricing models2.3.4.1 IntroductionAs indicated by Bruun (2001), using the Black-Scholes (1973) option pricing modelwith the familiar five input variables is the most obvious point of departure for thosewish to value growth options. However, there has been a growing literature showsthat the assumptions underlying the Black-Scholes model are either too simplistic, orinappropriate when it comes to pricing real assets. Moreover, the estimation of severalof the input parameters that are needed in the Black-Scholes model is a less thantrivial exercise. Therefore, these problems more or less form the motivation and basisfor most of the valuation models for real options developed. A number of thesemodels are presented as follows.Typical examples are a range of ―special cases‖ of the Black & S cho les‘ m odeldeveloped by Merton (1973, 1976) and Cox and Ross (1973) shortly after itspublication in 1973. An example of this case is when the price process for theunderlying asset is discontinuous. In this case, the price process for most real projectswill appear to be very discontinuous since the market value parameters generally willbe sampled infrequently. Therefore, Merton (1976) presents an elegant model to dealwith this situation.Another feature of real projects is that they often involve a sequence of discretionaryinvestment opportunities. It can be said that investing a real option normally involvesfurther options. This is also known as compound options, which are first dealt with byGeske (1977, 1979). When a R&D project consists of several rounds of financing,they should be thought of as compound options. When the length of each financinground can be extended, L ongstaff‘s (1990) m odel for pricing options w ith extendiblematurities can be applied.Finally, an approach that is both simple and intuitive for both real and financialPage | 20

options applications is the binomial/lattice approach first suggested by Cox et al(1979).2.3.4.2 Binomial Trees ModelThe binomial model assumes that the time to the option‘s maturity can be divides intoa number of subintervals in each of which there are only two possible stock pricechanges. This means that, compared to the price today, the value of the stock willeither increase by an upward multiplication factor u with the risk-neutral weightingfactor p, or it will decrease by a downward multiplication factor d with the probability1-p.It should be borne in mind, that in evaluating an option, the risk-neutral weightingfactor p should be used, rather than actual probabilities q. we can derive p accordingto the following equation:p = (er*delta(t) –d )/(u-d),rather than:After having derived the risk-neutral weights we can resolve the tree for the option byapplying a ―roll-back‖ procedure determining the value of the call option in eachperiod back to the presence.2.3.4.3 Black and Scholes ModelThe approach of pricing an option by creating option equivalents from common stockand a loan is generally valid, and independent from the number of periods and stockprices movements that are being considered. The binomial methods, described above,is a simplified approach to option valuation that reduced the possible changes of thestock price in the next period to two outcomes only. The methods would becomeincreasingly more realistic if shorter interval were used, with each interval displayingPage | 21

two values of the stock price that might occur. This procedure would provide a widerrange of possible stock prices for a given time period.Using indefinitely small periods, we would finally arrive at a situation where the stockprice changes continuously, generating a continuum of possible prices. In theirfamous publication of 1973, Black, Merton and Scholes derived an equation thatallows us to value options that have a constantly changing underlying asset (this is theusual case for assets such as stocks). The so-called Black-Scholes model can beconsidered as the ―continuous-time version‖ of the binomial tree.The Black-Scholes model is based on the following assumptions:Firstly, it can value European options only (where the option is exercised at a fixeddate); secondly, the assets do not pay dividend; thirdly, the volatility of the underlyingasset is constant; fourthly, the value of the underlying asset is log normally distributed;and finally, the interest rates are constant.For valuing a call option, the equation is defined as follows:Value of the call option C = SN(d1)-Ee-rt(d2)Where:N(d1): cumulative normal probability density function (i.e. the probability that anormally distributed random variable will be less that, or equal to d)S: current value of the underlying asset (current stock price)E: exercise price (it is discounted to the presence with the continuously compoundedrisk-free interest rate, i.e. by multiplication with e-rt )Page | 22

t: years to expirationr: annual risk-free rate of returnv: standard deviation per year of rate of return on stock2.3.5 Compound OptionIn the real world, real options are often compound options. Also known as option onoption, a compound option is like a standard option, but its underlying asset is antherstandard option. And the values of compound options are extremely sensitive to thevolatility of volatility. The valuation of compound option is first analysed of Analyticformulas by Geske (1979), and then by Hodges and Selby (1987) and Rubinstein(1991). A compound option can be simultaneous, or sequential.There are four types of compound options: Call on a call, Put on a call, Call on a putand Put on a put. And the third type, a call on a put, gives the holder the right to buy aput option. In this case, on the first exercise date, the holder of the compound optionis allowed to pay the first strike price and receive a put option. The put option givesthe holder the right to sell the underlying asset for the second strike price on thesecond exercise date.Consider under a Black-Scholes environment (that is: the underlying asset is follow alognormal random walk, the risk-free interest rate is used as the discount rate and theunderlying asset price is expected to appreciate at the same risk-free rate, and allow arisk-neutral valuation.2.3.6 Monte Carlo SimulationMonte-Carlo simulation is also known simply as simulation. Suppose we know howto value a derivative if only we knew the cash flows, and we know the cash flows arerandom while we have a model for the random effects. Then these components can beput together to create a valuation method.Page | 23

The main methodology is as follows: firstly, a sampling procedure is used tocalculated the expected payoff from the derivative instrument; next, several likelypath (assuming risk neutral) are simulated for each of the underlying variables; Then,for each path, the payoffs are calculated and discounted back at the risk-free rate ofinterest; and finally, the average of all the paths equals the value of the derivative. ForAmerican style derivatives, however, modifications need to be made.2.3.7 Asset BehaviourMost Option pricing models are founded on a model of asset price movements that isbased on the assumption that tomorrow‘s asset prices cannot be predicted and areunknown. Therefore, suggesting that prices move randomly. Hull (2003) suggests thatseveral stochastic processes can be used to model the bahaviour of the assets whosevalue changers over time in uncertain ways.2.4 Brief summaryIn this chapter, the concept of Real Options valuation approach was explored. Itsusefulness was reviewed by analysing its advantages over the traditional valuationmethods like NPV. The basics of the option pricing theory were reviewed, speciallyaddressing that the risk neutral valuation principle is the perfect framework for optionpricing. Moreover, the option pricing models were presented and their usefulness forreal option valuation was explored including the Monte Carlo SimulationMethodology and basics of asset behaviour. Meanwhile, the concept of combinationof options and compound options were also discussed.In the next chapter, the application of real options valuation method to R&D projectsin pharmaceutical companies is presented.Page | 24

Chapter Three— Apply Real optionsevaluation to R&D projects inpharmaceutical companies3.1 Typical drug development processReal options has been used widely in areas like Research and Development (R&D).And quite a few authors who concern about real options have addressed to theapplication of real options to R&D, including Howell et al. (2001), Paxon (2003),Schwartz (2002), Smith and Trigeorgis. Suggested by Schwartz and Moon (2001), theanalysis of investments in R&D is one of the most difficult problems of investmentunder uncertainty. In R&D projects, which are usually irreversible, there isuncertainty about the investment cost, the future payoffs from the investment, and thepossibility of unforeseen catastrophic events that may terminate the whole effort. Theproblem might seem to be of such complexity as to preclude the possibility ofsystematic ways to deal with it. The analysis of investment projects as complexoptions has been a subject of much research in the past 10 years. It has been applied tovalue mines (Brennan and Schwartz, 1985), oil leases (Paddock, et al., 1988), andprojects with uncertain cost (Pindyck, 1993), among many others.For pharmaceutical companies, the situation may be more complicated. For example,a pharmaceutical company who goes through a FDA drug approval process requiresthree stage of testing, and drug research can be abandoned after each stage.Meanwhile, the FDA approval may have to go through human trials, and the successof the FDA approval depends heavily on the success of human testing, both of whichoccurring at the same time.Page | 25

There are two examples for the process of R&D in pharmaceutical companies. Thefirst one (below) argues that it takes 12 years on average for an experimental drug togo to the market.Figure 3.1: Stages in Drug Development of a typical project 1And the second one states that it takes even longer.Figure 3.2: Stages in Drug Development of a typical project 2In the process of R&D for pharmaceutical companies, conventional valuationmethods may not work as well as the real option valuation method, as uncertainty canbe better managed in the latter case.The typical drug development process which is going to be presented below is basedPage | 26

on Howell et al (2001).3.1.1 Preclinical TestingAccordingly to Howell et al (2001) that before a drug may enter phase I clinical trials,it exists in what is known as preclinical testing. As specified, that at this early stage ofthe process, a new molecule has been discovered and is being investigated in bothlaboratory experiments and animals models. In order to carry out the work,researchers have been assigned exclusively as opposed to clinical development people.The purpose of nonhuman experimenting is to prove that the substance may be usefulfor a specific application in humans and cause a potentially useful biological effect. Inaddition, potential safety and biological activity of the drug are assessed in this stageand patens are filed and investigated in order to make sure that some sort ofproprietary position in the drug might be gained. Moreover, as Howell et al (2001)addressed that it takes about 2 years to accomplish the stage and only one percent ofthe molecules pass from preclinical testing into phase I clinical trials.3.1.2 Phase I Clinical TrialsBefore to start testing on human it is essential to submit an Investigational New Drugto the FDA, and if the FDA does not reply within 30 days, phase I testing may begin(Howell et al 2001). This stage intends to assess the toxicity and dosing of the drug inhum ans. A s indicates in H ow ell et al (2001)‘s case, that there are usually 20 to 80healthy volunteers taking part of the drug safety test. Again, it takes about 2 years forsuch trials and drugs with serious enough toxicity effects in humans will then beexcluded for development. However, about 70% of drugs entering this stage make itto the next phase of development, Phase II.3.1.3 Phase II Clinical TrialsA s detailed in H ow ell et al (2001)‘s case that the purpose of P hase II is to verify thebiological effectiveness of the drug, profiling the side effects, and obtaining dosinginformation. In comparison to Phase I, Phase II consists of 100 to 300 sick subjects,Page | 27

which is a much bigger scale than Phase I. These trials also take two years and about47% of drugs pass from Phase II into Phase III trials.3.1.4 Phase III Clinical TrialsThis phase is different from the other phase as it is to demonstrate statisticalsignificance of the drug (Howell et al 2001). Accordingly, trials are typically doubleblind and employ randomization and test versus control group (Howell et al 2001).This phase has to be carefully designed because it seeks for the approval of the drugfrom the FDA. As a result, studies are designed to be as clear as possible to indicatethe significance and function of the drugs. In other words, it is important to show theefficacy of the drug by focusing on specific conditions even it may not necessarilycomprise a lucrative market (Howell et al 2001). This is because doctors can use FDAapproved products for any use that they believe is appropriate even if FDArecommended drugs to be marketed for a particular indication.As mentioned in Phase II that the trials are quite big, however, in this Phases, thetrials consist of from 1000 to 3000 sick people, which is 10 times bigger that Phase II.As this is such a large number, huge expenditure will occur. One of the mostexpensive expenditure is a plant that manufactures the drug commercially, which canrange from 50 to 80 million dollars (Howell et al 2001). These trials last one moreyears than the previous trials and approximately 82% of drugs in phase III pass to thenext phase.3.1.5 FDA approvalIn order to acquire approval from FDA for marketing it is a must that firms send allthe evidence that indicating the drug has been effective and safe. According to Howellet al (2001), a Product License Application is sent in the case of a biopharmaceuticalfirm, and a New Drug Application is sent in the case of a traditional pharmaceuticalfirm. The revision of these applications takes about 2.5 years and the FDA can requireany more additional information. Nonetheless, on average 74% of the drugs arePage | 28

approved.3.2 real options valuation in pharmaceutical industry3.2.1 IntroductionIn chapter two, real options valuation has been described, and the reason thattraditional DCF methods are not appropriate to evaluate R&D projects has also beenmentioned. Moreover, the financial algorithms used to evaluate stock options havebeen examined. Thus this session intends to examine the scope of financial algorithms,development for capital markets and their application to the evaluation of real options.The underlying advantages and difficulties will also be discussed.The value of stock options can be determined by using discrete time models like thebinomial method, where only two possible stock price changes are defined for eachinterval. Or the continuous-time models according to the Black-Scholes approach,which assumes that the stock price changes continuously. As the author specifies, thatboth methods are based on the assumption that option equivalents can be constructedcombining stock investment and borrowing, where the cost of buying the optionequivalent is identical to the value of the option. The risk-neutral valuation approachcan be applied to transform the cash flows that are associated with the asset intorisk-neutral cash flows, which can be then be discounted at the risk-free rate(Bode-Greuel, 2000).This is to say, when a real asset could be traded, the way to value financial options onthe capital market would be identical for one to value this real asset, given that thereal asset is sufficiently similar to its comparable asset. If so, managers will be able touse the advantages of option pricing methods compared to other dynamic cash flowmethods such as decision analysis or dynamic DCF analysis.The main advantage of using the option pricing methods is that decision makers canPage | 29

use the inform ation derived from the traded ―tw in‖ asset, w hich is the risk of theproject to be evaluated is taken into account by determining the volatility of the valueof the twin asset (Bode-Greuel 2000). In other words, there is no need for decisionmakers to make judgmental probability estimates or measures of risk aversion.T herefore, it is a convenient w ay o f determ ining a project‘s contribution toshareholder value by using the available information from the twin asset.Market risk is one of the most important factors affecting investment decisions in thepharmaceutical industry. Option is one of the ways to eliminate the risk. For instance,a company may construct the production facility in two stages and make finaldecision at a later stage by considering the development of the market. Option is whatthey can obtain to expand the production of a drug if the demand for the drugincreases in the future.As Bode-Greuel (2000) advocates, that the initial investment in the first stage ofconstruction can be considered as the price of the call. This is because the exerciseprice would refer to the remaining cost of construction once the proceeding to thesecond stage decision has been made. Referring to the expiration of the option, thetime over which the decision to start with the second stage can be postponed(Bode-Greuel 2000). Moreover, the value of the underlying asset can be seen as theadditional net revenue, which can be generated over the time of use of additionalproduction facility and limited by the assumed lifecycle of the product. Risk isrepresented by the volatility of turnover.Page | 30

Figure 3.3: Comparison of a call option with an investment a new production plantThe example discussed above illustrate that the analogy between stock options andreal options is a close one:- when the underlying asset is traded- when market risk is the predominant type of uncertaintyHowever, this is not always the case in the pharmaceutical industry, and the situationappears especially complex for R&D. in this stage of new product generation, risk isnot only driven by exogenous factors that are reflected in the volatility of sales, thevalue of R&D projects is also strongly determined by endogenous risks. These areproject-specific risks related to the R&D process. During the course of R&D, projectshave to overcome many technical hurdles, only about 10% of those projects that enterdevelopment result in a marketable product. Ninety percent are terminated at somemilestone and R&D costs are almost always sunk.Thus, endogenous and exogenous risks in pharmaceutical R&D are correlated anddertermined by multiple factors. R&D projects are often unique, such that they cannotbe replicated by assets traded on capital market. This makes application of financialoption pricing methos in R&D more complex than in natural resource andcommodities industries.Page | 31

3.2.2 Five variables that determine the value of financial options –analogies toreal R&D options in pharmaceutical companiesAs a starting point for discussing option pricing methods in R&D, table 5.3 illustratedthe analogies between stock options and real options in R&D.-Underlying asset: Present value of the expected net cash flows resulting from themarketed product-Exercise price: present value of remaining R&D cost-Risk: Volatility of drug turnover of a comparable marketed product; or volatility ofstocks of comparable businesses-Time to expiration: time until R&D opportunity is lost-Interest Rate: risk-free interest rateFigure 3.4: analogies between stock options and real options in R&D projectEach of the five variables that determine the value of financial options is discussed inthe following sections, with respect to its meaning the relevance to real options.3.2.2.1 Exercise priceFor stock options, the exercise price refers to the amount that has to be paid when theoption is exercised. The exercise price is paid in one installment on the day ofexercising. Applied to real options in R&D, however, the exercise price is usually notpaid in one installment, but as ongoing expenses. And it refers to the remaining costthat has to be assumed to obtain a marketable product.R&D costs can often be forecast with reasonable certainty. When R&D is undertakenwith contract research institution, the price is clearly defined in the contract; cost ofR&D activities pursued in-house can be predicted with reasonable accuracy byPage | 32

applying the principals of activity-based costing and by referring to historical costs ofcomparable projects. Furthermore, databases such as the Pharmaceutical R&DCompendium (CMR International Reports, 1999) as well as scientific publicationsprovide benchmark information about R&D costs. However, in specific cases, thecosts relating, for instance, to difficult clinical studies or new ways of Galenicdevelopment may be highly uncertain. This uncertainty can be addressed by a propersensitivity analysis.3.2.2.2 Time to expirationThe time to expiration specifies the time at which the option expires. Applying topharmaceutical R&D, the time to expiration refers to the time at which the R&Dopportunities disappear.3.2.2.3 Stock priceApplying to real assets, the underlying asset is the present value of the cash inflowsarising from the marketed product, minus the ongoing production, distribution andmarketing costs. If a market-traded twin asset can be identified, i.e. an asset with avalue that moves similarly under changing market conditions, evaluation of theproject becomes easier by using the real option approach, compared to DCF ordecision analysis.3.2.2.4 Volatility of the value of the underlying assetOption pricing methods use the volatility of the market value of an asset as a measureof risk. Volatility is defined as the standard deviation of the rate of return on theunderlying asset. The volatility parameter indicates how the market perceives the riskprofile of a particular asset. Thus, financial option pricing focuses on exogenous risk.However, real options are usually more complex than financial options. They havemultiple sources of uncertainty, and combine both exogenous and endogenous risks.Page | 33

Endogenous risks that are related to the successful completion of a project are usuallynot well captured by the market. They may enhance the value of the project byincreasing the spread of possible outcomes. Endogenous risks may also decrease thevalue of a project. Because of the high impact of endogenous risk in pharmaceuticalR&D, defining an appropriate volatility parameter is difficult. Different approacheshave suggested in defining volatility, and these are discussed below.Applied to pharmaceuticals, exogenous risk is determined by development of themarket of the pharmaceutical market; e.g. cost containment measures, insurancecompany practices or health political decisions. The value of stocks of pharmaceuticalcompanies reflects these factors. Therefore, it has been suggested that the volatility ofa stock index of pharmaceutical companies be applied as a measure of exogenous risk(Amran &Kulatilaka, 1999). Alternatively, Merck & Co applies the volatility of abiotechnology index of related stocks traded at NASDAQ to evaluate early stageR&D projects. (Nichols, 1994)According to Teisberge (1995), the underlying asset of a real option is the completedproject which, in the pharmaceutical industry, refers to the marketed drug. Thevolatility of the value of the already marketed ―twin‖ asset could then be used toevaluate the current project; it could be derived by analysing the volatility ofrevenues.There are different types of volatility: historical, forecast, implicit, seasonal and future.To determine a suitable volatility parameter, different methods should be used.Whichever approach is used, the volatility parameter should reflect the expectationsof investors about the value of an underlying asset may develop during the lifetime ofthe option.Historical volatility: historical volatility of the underlying asset is defined as volatilityPage | 34

that has occurred in the past. Depending on the asset selected as reference for theproject to be evaluated, it may be the historical volatility of a stock index of eitherpharmaceutical or biotech companies. Alternatively, one could use the volatility ofrevenues of a drug that has a similar product profile as the drug that is supposed toemerge from R&D. The historical time period chosen to define an asset‘s volatilityshould correspond to the lifetime of the option. Historical volatility ahs beensuggested by most authors as a basis for real options evaluation in the pharmaceuticalindustry, assuming that an asset‘s volatility will be driven by comparable factors in thefuture.Forecast volatility: specialist companies or experts provide forecast volatility. Thismay be the preferred approach when stock indices are used as reference for theunderlying asset.Seasonal volatility: some pharmaceutical products may have a seasonal volatility,such as influenza vaccines, or cough and cold medicines. This should be taken intoconsideration when a general volatility parameter is determined to reflect the risk ofthe product.Generally, volatility can be estimated as below.Volatility is defined as the standard deviation of the continuously compounded returnon an asset. The continuously compounded return of an asset is defined as:u t = ln (I t /I t-1 )Where:u t: return between time t-1 and tI t: asset value at time tI t-1: asset value at time t-1Volatility is then calculated based on the formula below:Page | 35

3.2.2.6 Risk-free interest rateThe risk-free interest rate applied should correspond to the interest rate that it isappropriate for; e.g. treasury bills with an identical lifetime as the real option.3.3 Brief summaryIn this chapter, the typical process of drug development is reviewed and analogies ofthe option valuation method to real R&D options in pharmaceutical companies wereanalysed.In the next chapter, the case study of Davanrik at Merck & Co. will be introduced.Page | 36

Chapter Four— Case StudyFor this paper, the methodology of case study will be used. It is a case of apharmaceutical company with acquiring the compound ‗Davanrik‘. For applying thereal options valuation method to this case, binomial trees approach is chosen to valuethis particular compound, as this approach is considered to be more appropriate tovalue Pharmaceutical R&D projects than other option pricing models likeBlack-Schole model. The reason is for the complexity of this particular case and thatbinomial trees approach accounts for both sources of uncertainty (technological andeconomic) and sequential nature of R&D projects. Furthermore, it was identified thatstrategically important information changing the value of discovery projects, arrivesin a discontinuous way. This process is properly approximated by the binomial treesmodel.In this chapter, the case study of Davanrik at Merck & Co. is going to be introduced.It is a case that a few overseas universities have referred to when introducing theconcept of net present value. The following part of this chapter will introduce thewhole case regarding to Davanrik and Merck & Co. Noting that some information ispresented here for the integrity of the case, for example, the license payment androyalty Merck & Co. pays or would pay to LAB Pharmaceuticals. These will beignored when applying the real option valuation method.4.1 IntroductionRich Kender, Vice president of Financial Evaluation & Analysis at Merck, wasworking with his team to decide whether his company should license Davanrik, a newPage | 37

drug with the potential to treat both depression and obesity. The small pharmaceuticalcompany concern that developed the drug, LAB Pharmaceuticals, lacked theresources to complete the lengthy approval process, manufacture the compound, andmarket the drug. LAB had approached Merck with an offer to license the compound.Under this agreement, Merck would be responsible for the approval of Davanrik, itsmanufacture, and its marketing. The company would pay LAB an initial fee, a royaltyon all sales, and make additional payments as Davanrik completed each stage of theapproval process.4.2 Merck CompanyIn 2000, Merck & Co. Inc. was a global research-driven pharmaceutical company thatdiscovers, develops, manufactures and markets a broad range of human and animalhealth products, directly and through its joint ventures, and provides pharmaceuticalbenefit management services (PBM) through Merck-Medco Managed Care. Since1995, Merck had launched 15 new products including Vioxx for the treatment ofosteoarthritis, Fosamac for the treatment of osteoporosis and Singulair for treatingasthma. The company earned $5.9 billion on 1999 sales of $32.7 billion, about a 20%increased from 1998.A handful of Merck‘s most popular drugs, Vasotec, Mevacor, Prinivil, and Pepcid,generated $5.7 billion in worldwide sales. The patents for these drugs, however,would expire by 2002. Once the patents expired, Merck anticipated that the sales ofthese drugs would decline substantially as generic substitutes became available. Theonly way to counter the loss of sales from drugs going off patent was to develop newdrugs and constantly refresh the company‘s portfolio. The companies develops newcompounds primarily through internal research, but complements this throughinitiatives with biotechnology companies to ensure Merck is on the leading edge ofselect therapeutic categories.Page | 38

4.3 DavanrikLAB Pharmaceuticals originally developed Davanrik to treat depression.Antidepressant drugs work by affecting certain parts of the central nervous system.Various receptors in the human brain, when stimulated or blocked, create or inhibitvarious moods. The serotonin system controls nervousness, depression insomnia,hunger, sexual dysfunction, nausea, and headaches. Through a combination ofchemical compounds, the receptors in this system of cells can be stimulated orblocked to treat a patient with one or more of the given symptoms. Davanrik seemednot only to stimulate the receptor that promotes anti-depression, but also to block thereceptor that causes hunger.At the time of LAB‘s offer, Davanrik was in pre-clinical development, ready to enterthe three-phase clinical approval process required for pharmaceuticals in the UnitedStates.LAB Pharmaceuticals specializes in developing compounds for the treatment ofneurological disorders. While the company was only 5 years old and though it had afew drugs in Phase II and Phase III testing, none had successfully completed the FDAapproval process. In fact, the FDA had recently denied approval of another of LAB‘scompounds that had completed all three phases of clinical testing; LAB‘s stock pricefell by over 30% in response to this decision. As a result, LAB was hesitant to issueadditional equity to finance the testing of Davanrik and was seeking a largerpharmaceutical company to license the drug and provide LAB with somemuch-needed cash. The licensee would design, administer, and fund the clinicaltesting of the compound, its manufacturing and its marketing. The licensor, LAB,would receive an initial payment followed by additional payments as Davanrikcompletes each clinical testing phase. LAB would also receive a royalty on theeventual sales of Davanrik.Page | 39

4.4 Davanrik’s Potential Cash flowsRich Kender assembled a team to evaluate the potential profitability of Davanrik.Senior researchers evaluated scientific aspects of the compound, and marketersevaluated the market size, potential competition, and requirements to successfullylaunch the drug. Meanwhile, manufacturing managers determined the capital requiredto produce the drug, and people in Kender‘s own department built a financial analysisof the licensing decision.The evaluation team determined the costs and likelihood of completing each stage ofthe FDA approval process along with a forecast of profitability of the drug if itsuccessfully completed the approval process. Overall, the approval process wasexpected to consume about seven years. LAB obtained a patent on the product whichis estimated to have a remaining life, including all possible extensions, of 17 years.Therefore, the product would have a 10 year period of exclusivity, beginning in 7years.Phase IDavanrik would be administered to 20-80 healthy people to determine if the drug wassafe enough to continue into the efficacy stages of clinical testing. Phase I would taketwo years to complete. It was expected to cost $30 million, including an initial $5million fee to LAB for licensing the drug. There was a 60% chance that Davanrikwould successfully complete Phase I.Phase IIIn this phase, Davanrik would be given 100-300 patient volunteers to determine itsefficacy to treat depression and/ or weight loss and to document any side effects. Tocomplete the efficacy tests, Davanrik would have to demonstrate a statisticallysignificant impact on patients suffering from depression, obesity, or both. The Merckteam estimated a 10% probability that Phase II would show that Davanrik would bePage | 40

efficacious for depression only, a 15% probability for weight loss only, and a 5%probability that it would be efficacious for both depression and weight loss at thesame time. It is worth noting here, according to FDA, a pharmaceutical must provedual indications in addition to proving each indication separately if it wants to be ableto claim therapeutic effects for people from both disorders. Like Phase I, Phase IIwould require two years of clinical testing to complete. Phase II was expected to cost$40 million, including a $2.5 million licensing milestone payment to LAB.Phase IIIIn Phase III, Davanrik would be administrated to 1000-5000 volunteers to determinesafety and efficacy in long term use. Because of the number of volunteers and natureof testing, this was the most costly of the phases and was expected to take three yearsto complete. The costs and probabilities of success depended on the outcome fromPhase II. If Davanrik was effective for only depression, Phase III trials would cost$200 million including a $20 million payment to LAB, and have an 85% chance ofsuccess. If it were effective for weight loss only, it would cost $150 million includinga $10 million LAB payment, and have a 75% chance of success. If, however, it wasefficacious for both weight loss and depression, more specialised trials would berequired to determine efficacy for the dual indication. The total cost of the Phase IIIclinical tests for the two separate indications together with the dual indication wasexpected to be $500 million, including a $40 million licensing payment to LAB, andhad a 70% chance of successful outcome. Under this scenario, there was a 15%chance of a successful outcome for depression only, and a 5% chance of a successfuloutcome for weight loss only. The probability of complete failure of the dualindications or either separate indication was only 10%.Davanrik had substantial potential profits, especially if it was effective both as atreatment for depression and weight loss, if the drug were approved only for thetreatment of depression, it would cost $250 million to launch, and had acommercialization present value of $1.2 billion. If Davanrik were only approved forPage | 41

weight loss, it would cost $100 million to launch, and would have a PV of $345million. However, if Merck could launch the product with claims for both indications,it would cost $400 million to launch and have a PV of $2.25 billion. It is assumedhere, if the compound has successfully passed all the three phases, the possibility forthe compound to entering the market is 100%, regardless of the FDA approval andother issues.Page | 42

Chapter Five— Case Study Analysis5.1 NPVBased on the case described in the case above, the figure below summarises theprocess of the project‘s three Phases with possible outcomes. Note here, as given inthe case, all the cash flows given in the case earlier have been discounted to thepresent at the weighted average cost of capital of the company (assumed to be 10%).Figure 5.1: R&D Process of Davanrik at Merck & Co.If we work the tree backward, and take advantage of the fact that we have the optionto choose whether to invest $40 million at the end of Phase I and invest at the end ofPage | 43

Phase II and Phase III, then we can avoid these investments. It is assumed that weonly abandon the project if the phases fail. This situation can be illustrated as below:Figure 5.2: NPV of Davanrik at Merck & Co. 1The present value (PV) of this project is:{{[(1200-250)*.85+0*.15-200]*.1+[(345-100)*.75+0*.25-150]*.15+[(2250-400)*.7+(1200-250)*.15+(345-100)*.5+0*.1-500]*.05+0*.7}-40}*.6+0*.4= {[(807.5-200)*.1 + (183.75-150)*.15 + (1449.75-500)*.05 +0]-40}*0.6+0= (113.3-40)*0.6= 43.98NPV = 43.98 – 30 = $13.98 millionThis result can also be derived from another perspective, which is illustrated in thePage | 44

figure below:Figure 5.3: NPV of Davanrik at Merck & Co. 2Here, ten different outcomes have been analyzed, together with their probabilities.For example, for the first outcome, CF = 1200-250-200-40-30 = 680, while theprobability of this situation is 0.6 * 0.1 * 0.85 = 5.1%, so the PV of this situation isCF * probability = 680 * 5.1% = 34.68.Putting all the possible outcomes together, gives the NPV of $13.98 million.Except the option to abandon described above, there are other possibilities of realoption in this Davanrik case. This will be discussed in detail in the section below. (Itcan also be argued that the options to abandon described above have no value offlexibility, as discussed in Chapter 2).Page | 45

Between the end of year 7 (the time to decide whether to launch the compound) andthe end of year 17 (the time when the patent of Davanrik expires), there areuncertainties, leading to the existence of real options. Between the end of year 0 (thetime to decide whether to invest on this compound) and the end of year 7, there areother real options, as huge uncertainty also exist. If the options from year 0 and year 7is considered as a single option (known as Option A), then it, together with theabandonment option for the period between year 7 and year 17 (known as Option B)can be seen as a compound option, where Option A must be exercised in order to keepOption B open. For a compound option, a single binomial tree could be used to derivethe value. But in this case, Option A is a complex compound option as well, and as itis going to illustrate below, it is assumed that option A and option B have differentvolatility and risk-free rate. So here the values derive from Binomial Trees (BT) forOption B (the second BT) would be added to the last branch of the first BT.5.2 Option B (Year 7 to year 17)5.2.1 Five variables that determine the value of the optionsBetween the end of year 7 (the time to decide whether to launch the compound) andthe end of year 17 (the time when the patent of Davanrik expires), Merck & Co canchoose to abandon the project, at any time before the patent ends (so that there is stillsalvage value), or Merck can expand the scale at a cost or extract with a saving.However, as discussed in Chapter 2, the option to expand, extract, or defer may leadto other concepts, it is assumed here, Merck & Co only has the option to abandon, forthe time between the end of year 7 and the end of year 17. And since this option canbe exercised at any time, it can be seen as an American put option.The value of the underlying asset – it should be the ‗present‘ value of the net cashinflow from the project, but since this option begins in year 7, the ‗present‘ value of$1200m, $345m, $2250m should be discount ‗forward‘ to the end of year 7 to get thecorrect ‗present‘ value at year 7, by using the weighted average cost of capital ofPage | 46

Merck & Co (10%), which gives $2338m, $672m, $4385m respectively.The time to expiration – as the compound is going to go through a 7 year R&Dprocess, and the patent still has17 years of life, the product would have a 10 yearperiod of exclusivity, beginning in 7 years. The time between year 7 and year 17leaves 10 year of time, which can be deemed as suitable for expiration time. Assumeyear 0 is the year 1999, thus for this option, T is the year 2016 and t is the year 2006.Volatility – ten years of Merck & Co‘s stock price has been used to derive thestandard deviation (S.D. = 49.61%) for the time period between year 7 and year 10.Here the historical volatility of Merck & Co is used, rather than the Davanrik, or say,LAB Pharmaceuticals. As will be discussed later that for other period, meaning year 0to year 7, other volatility figure will be used, this is because for the time between year0 and year7, the volatility would be more project-related, especially in terms of LABPharmaceuticals‘ past performance. It is assumed for that period, the volatility wouldbe higher, as the fact that LAB has never passed the process.Page | 47

Figure 5.4: Volatility estimation for option from year7 to year 17Exercise price – in this abandonment option, the exercise price would be the salvagevalue of the project, which in this case, is assumed to be the value of the patent. Sincethe patent is going to expire in year 17, so at year 17, the patent‘s value is 0. And thevalue of the patent is decreasing over the period, as the potential buyer of the patentwould be willing to pay less as the time approaching the expiration of the patent. It isalso assumed that the patent is decreasing on a ‗straight line‘ way, so each year woulddecrease 1/10 of its original value.Risk-free rate – the risk-free rate of 4.37% is referred to the US Ten-Year Treasuryon the 3 January 2006, which will expire in 2016 (T). The chosen of this particularTreasury is to correspond to the expiration of the option.5.2.2 Valuation of the abandonment option (Option B)It is assumed here, if the compound has successfully passed all the three phases, thepossibility for the compound to entering the market is 100%, regardless of the FDAPage | 48

approval and other issues. Therefore, there is no technical uncertainty regarding toOption B, but only market, or say, economic uncertainty. The mention of this point isto make Option B differ from Option A, and this will be explained in detail in latersection.Based on the assumptions and analysis above, a 5-step binomial tree is used to derivethe option value for the three separate situations (where the compound is found to beuseful for depression only, weight loss only, or for both).Figure 5.5: Valuation of Option B (underlying: Depression)Given the variables above, and assumes the patent would worth $2000m in Year 7 (inyear 2006), in the case that the compound is found to be useful to depression only andhave a PV of $1200m at year 0 (which is $2338.46m at year 7). In two years, thevalue of patent would drop by 1/5 of its original value (that is $400m for two years),Page | 49

which gives the salvage value of $1600m in year 9. And eventually, in year 17, thereis no salvage value as the patent expires.Here, in the lowest case for the year 15, V= max {{exp(-rh)*[pVu+(1-p)Vd]}, (X-S)}= max [0, (400-141.3)] = 258.7. As {exp(-rh)*[pVu+(1-p)Vd]} < (X-S), the option isearly exercised.The result of the binomial tree shows that the value of the abandonment option is$245.67m, so the PV * (PV+O) = PV + Option value = 2338.46 + 245.67 =$2584.13m.Figure 5.6: Valuation of Option B (underlying: Weight loss)In the case that the compound is found to be useful to weight loss only and have a PVPage | 50

of $345m at year 0 (which is $672.31m at year 7), it is assumed that the patent wouldworth $600m in Year 7. And the salvage value would drop by $120m every two years.Similar as the situation above, the abandonment option adds a value of $81.78m to thepresent value, which gives PV * (PV+O) = 672.31 + 81.78 = $754.09m.Figure 5.7: Valuation of Option B (underlying: Both)In the case that the compound is found to be useful to both depression and weight loss,while the PV is $2250m at year 0 (which is $4384.61m at year 7), it is assumed thatthe patent would worth $4000m in Year 7, and the salvage value would drop by$800m every two years.Page | 51

And for the last situation, the $4384.61m is the PV without flexibility, the $572.14mis the real options value, and the combined value $4956.75m is the PV * , i.e. Presentvalue with real options flexibility.Table 5.1: Value of Option BAs illustrated in the table above, the realize of the real options for the time periodbetween year7 to year17 (Option B) could increase the expected present value to$1362.07m, $386.97m, and $2543.60m (value at year 0) respectively, which leads to a$16.06m increase in the NPV, thus makes the NPV*(NPV after realizing real optionfrom year 7 to year 17) $30.04m.To summerise, the value of Option B is $16.06m, in term of increasing in NPV, with:V Bd (Depression) = $245.67m;V Bw (Weight Loss) = $81.78m;V Bb (Both) = $572.14m.These are the values to be added to the last branch of the BT of Option A.5.3 Option A (Year 0 to year 7)Again, it is assumed here, Merck & Co only has the option to abandon, for the timeperiod between the end of year 0 and the end of year 7. Merck & Co can choose toabandon the project, not only when the test fails, but also it can abandon when thePage | 52

project turns out to be unprofitable.The first option is at the end of year 2, when Merck & Co. can choose whether or notto abandon. The second is at the end of year 4, and the third is at the end of year 7. Asall the options can only be exercised at a specific time (i.e. when the Phase ends), itcan be seen as a European option. Moreover, since the third option only exist if thesecond option is open, and the second only exist when the first option is open, theycan be seen as a sequential compound option.Furthermore, as there are two kind of uncertainty regarding to this option, it can beseen as a compound rainbow option. The valuation of a compound rainbow option canbe calculated from a binomial tree approach. However, as result of the complexity ofthis compound option, the valuation of this compound rainbow option can be ratherdifficult. As will see later, there are three underlying assets, which have five differentprobabilities of success for Phase III, and recombined as three probabilities at Phase II,it would be very complicated to construct a single binomial tree in order to value thiscompound rainbow option. Therefore, firstly, a simpler valuation approach is used, byvaluing three separate compound options individually, and then combining the valueusing their corresponding probabilities. After this valuation, the compound rainbowoption is valued by using a single binomial tree to compare the different results.5.3.1 Five variables that determine the value of the optionsThe value of the underlying asset – there are three underlying asset in this case,which are $1200m, $345m, and $2250m respectively.The time to expiration – in this case, as it is a compound option, T 1 is 2, T 2 is 2, andT 3 is 3.Volatility – as mentioned earlier, for the time period between year 0 and year 7, thevolatility would be more project-related. In this case, past performance of LABPharmaceuticals can also be used as a reference. Here, volatility could be calculatedusing the basic formula for standard deviation, and then transferred to yearly volatilityPage | 53

y using the formula S.D. (yearly) = S.D / Square root of number of years. Asillustrated in the table below, the standard deviation is as high as 95.45%.Figure 5.8: Volatility of Option A (Year 0-7)However, the use of these Probabilities of Technical Success (PTS) is not for options.According to Mun (2005), these PTS should be modeled in the DCF and can besimulated as well. These PTSs can be assumed to be statistically independent of eachother and can be multiplied with one another, or a correlation can be set among them.By simulating the model and use the resulting NPV as the expected value of theproject, after accounting for these PTS events, and then simulating the model againwithout these PTSs changing, the volatility can be captured. This volatility cancapture the uncertainties in the market events that determine what options will beexecuted. Due to time constraints, however, this method will not used, and a volatilityof 70% is assumed for the time period 0-7.Risk-free rate – to be precise, the risk-free rate should be the US Treasury bill withthe same period and corresponding to the expiration of the option. In that case, forPage | 54

these three options, the risk-free rate should be different. But for the sake of simplicity,it is assumed here for the 7 years, a single risk-free rate is used. Thus, the risk-freerate of 5.79% is used, referred to the US 7-Year Treasury in the year 1999, which willexpire in 2006.Exercise price – for the option, the exercise price generally refers to the cost to investto keep the option open. In this case, however, the situation is very complex and foreach phase, the exercise prices (cost to invest) are different, for each situation (i.e.Depression only, Weight loss only and both), the exercise prices are different. Thetable below shows the exercise price (exercise price) estimated to correspond to eachsituation and phase, noting that the figures are the value at the corresponding time,rather than the present value.The costs should be adjusted to the year of investing respectively, which makes $40mat year 0 become $48.4m at Year 2 (40*1.12),$200m at year 0 become $292.82m at Year 4 (200*1.14),$150m at year 0 become $219.615m at Year 4 (150*1.14),$500m at year 0 become $732.05m at Year 4 (500*1.14),$250m at year 0 become $487.18m at Year 7 (250*1.17),$100m at year 0 become $194.87m at Year 7 (100*1.17),$400m at year 0 become $779.49m at Year 7 (400*1.17).Summarized as below:Table 5.2: Time value of investment costPage | 55

The table below shows the exercise price for each situation at different times. Toillustrate, the exercise prices in year 4 and year 7 are simply the cost to invest for eachof the situations (i.e. Depression only, Weight loss only, and both). But for the optionended in year 2, a common cost of $48.4m should be adjusted. This is done by usingthe weighing of year 4 cost, since the cost of $48.4m is for the purpose of futuredevelopment, in other words, it depends on the weighing of money that Merck & Co.prepare to pay for each of the situations. The reason why only year 4 investment costis relevant is because, the spending of $48.4m is for the purpose to test if thecompound is useful for depression, weight loss, or both, and the subsequent cost foreach situation is seen as the suitable figure to estimate the amount of money thatMerck & Co. is willing to pay for each situation.Table 5.3: Exercise Price of Option A (Year 0-7)Based on these adjustments, the flow chart of the Davanrik R&D process can bePage | 56

ewrite as, noting all the costs (in figure 5.9) are the value adjusted to the real time:Figure 5.9: new flow chart of the Davanrik R&D process (real time value)5.3.2 Valuation of the compound option A using simple valuation methodFor the situation when PV = $1200m, option value V Bd (Depression) = $245.67m needto be add to the last branch of the binomial tree of Option A, which is at the end ofyear 7. At year 7, the value, V, is determined by max [(S-X+V B ), o]. The term(S-X+V B ) represents the situation when the earlier option is exercised, at cost X, but itcan get a value of flexibility. Or say, if and only if the PV together with flexibilityvalue is larger than the cost to continue it, the project can be continued, otherwise, itPage | 57

would be abandoned. But to note here, this compound option (Option A) is asequential of European options, and a call option as it is an option to continue.Page | 58

Figure 5.10: Valuation of Option A (underlying: Depression)As illustrated in the figure above, the value of the option (Depression as underlying)is $912.69 million.Similarly, for the situation when PV = $345m, option value V Bw (Weight Loss) =$81.78m is add to the last branch of the binomial tree of Option A, which is at the endof year 7. And the value of the option (Weight Loss as underlying) is $196.37 million,as illustrated in the figure below.Figure 5.12 shows the valuation of option while the underlying is 2250 (for ‗Both‘).At the end of year 7, option value V Bb (Both) = $572.14m is add to the last branch ofthe binomial tree of Option A. And the option value (Both) is $1704.12 million.Page | 59

Figure 5.11: Valuation of Option A (underlying: Weight Loss)Page | 60

Figure 5.12: Valuation of Option A (underlying: Both)Page | 61

ENPV (or say NPV + O), which is the NPV including the flexibility, can be calculatedas in the table below:Table 5.4 ENPVThe value of the Option A (which has included the value of Option B, as the way ofcalculation), can be calculated by multiply the Option Value of each situation (as justderived) by the probabilities of different outcomes, and add them together, whichgives $99.99 million. Alternatively, first multiply CF** (= Original CF + OptionValue of each situation) by the probabilities of different outcomes, add them together,(which gives the ENPV of $113.97 million), and then minus the NPV. The calculationshows that by using a binomial tree approach, the realization of real options hasincreased the NPV by $99.99 million, which is the value of flexibility.5.3.4 Valuation of the compound option –compound rainbow optionIn the figure below, the value of the compound rainbow option is calculated, withinconsideration of two separate but unrelated uncertainties, i.e. technical and marketuncertainties.Moving all the way back to year 0, the NPV (with flexibility) is $49.05 million. Andgiven the original NPV is $13.98 million, the value of the option is $35.05 million.Page | 62

Figure 5.13 Valuation of Compound rainbow optionPage | 63

5.4 Sensitivity Analysis and comparison of two methods5.4.1 Sensitivity AnalysisAs for Option A, the estimation of volatility is relatively rough, the sensitivelyanalysis is preferred to show the relationship between option value and volatility, andthe impact of volatility change to option value. Take the volatility with the range 40%to 70%, three compound options with different underlying asset value are calculated,and final option values are combined according to the corresponding probabilities, asshown in the table below.Table 5.5: Calculation for option value with different volatilityAs uncertainty is higher in pharmaceutical industry than other industries, carefulconsideration should be taken when applying real option valuation models topharmaceutical investment. When the range of volatility (e.g. 40% to 70%) in the realworld situation is incorporated for decision making, the option value is between$86.935 million to $99.99million, and the ENPV is within a range of $100.915Page | 64

$ in millionmillion to $113.97 million, derived from the first valuation method (simpler). Butusing the second method, the value of the option (Value of Option*) is within a rangeof $16.17 million to $35.07 million. And the relationship between option value andvolatility is shown as in the figure below:120.00100.0080.0060.0040.0020.000.00Value ofOptionValue ofOption*0.4 0.45 0.5 0.55 0.6 0.65 0.786.94 88.25 90.45 92.84 95.27 97.66 99.9916.17 19.33 22.51 25.69 28.88 32.01 35.07VolatilityValue of OptionValue of Option*Figure 5.14: Sensitivity Analysis for two valuation methods5.4.2 Comparison of two valuation methods and conclusionThe solution of option value A is derived from two methods. The first one is simpler,without any consideration of two sources of uncertainties, and the second one to valuea compound rainbow option is rather complicated, but with the incorporation of themarket and technical uncertainty (unrelated). And the value of the project is found tobe much larger by using first valuation method. Compared with the traditional NPVmethod, this method generates a value 7 to 8 times the original one. The secondvaluation method, the more accurate one, has increased the NPV from $13.98 millionto $49.05 million, with a $35.07 million option value. This result is quite influencingfor the investment decision concerning further financing, although is constrained byits limitations and therefore accuracy.To value this Davanrik project at Merck & Co., the second valuation method shouldbe used, as it incorporates with two separate and unrelated uncertainties. Valuation byusing the first (three separate binomial trees and combining the value according toPage | 65

their corresponding probabilities) could cause serious errors in option value. In all, theuse of real option valuation approach could increase the value of pharmaceutical R&Dinvestment, but the use of the suitable model is vital to derive a correct option value.Page | 66

Chapter Six— Limitations and conclusion6.1 limitations6.1.1 For Option BIn the valuation of this compound option, some rough assumptions have been made.Firstly, the estimation of volatility. It assumes no dividends have been paid during thetime of the options. And the assumption is rather simple, as is assumes same volatilityover the life period of the option B. This could be problematic in the real world, as thevolatility may not be know and may change over the life of the option, which couldmake the option valuation very complex. More importantly, the valuation methodused may not be the best suitable one for this case, and Monte Carlo Simulation maybe a better way to estimate the volatility. Due to time constraints, however, a simplervaluation method was used. Secondly, the assumption of salvage value. The salvagevalue of option B is assumed to be related to their value for each underlying assetvalue, and the estimation of salvage value did not incorporate issues like inflation.And finally, for this ten year option, a binomial tree of only 5 steps has been used. Allthese assumptions could affect the accuracy of the result.6.1.2 For Option AFirstly, volatility. As explained earlier in this chapter, the volatility for Option A couldbe simulated, but an assumption of 70% was made. Although the sensitivity analysisspecifically addressed the impact of the change of volatility on real option values, thiscould still be one of the factors that influence the accuracy of option valuation.Secondly, risk-free rate for option A is assumed to be a single one, for the sake ofPage | 67

simplicity. But the use of different risk-free rates could lead to more accurate result.Thirdly, the second valuation method is a simpler version of the quadranomialapproach. But due to time constraint, the present valuation method is used.6.2 ConclusionR&D investment in pharmaceutical companies like most real investments arecharacterized by a high level of future uncertainty, which influences the present valueof R&D projects is composed of technological and market uncertainties.The objective of this paper was to apply a richer decision-making tool, i.e. the realoption methodology for the valuation of multi-staged R&D projects. The paperhighlighted the main concept of real options, its common types, and the valuation ofreal options.A case study of Davanrik at Merck & Co. is used to illustrate the valuation of acomplex compound option, by using binomial tree method. Analysis of Davanrik‘sR&D process showed that at each stage managers have the possibility (i.e. right) tocontinue or to abandon the project in the case of technological failure and/orunfavorable market conditions. Option A (for the time period 0-7) and Option B (forthe time period 7-17) can be seen as a sequential compound option, while Option A isanother sequential compound, and Option B is an American put option assuming thatthe project can be abandoned at any time after the launch.The solutions by using binomial trees approach was applied to find the value of thiscompound option, as it was considered as the more appropriate to valuePharmaceutical R&D projects than other option pricing models like Black-Scholemodel. The reason is that this model accounts for both sources of uncertainty(technological and economic) and sequential nature of R&D projects. Furthermore, itwas identified that strategically important information changing the value ofPage | 68

discovery projects, arrives in a discontinuous way. This process is properlyapproximated by the binomial trees model.The solution of option value A is derived from two methods. The first one is simpler,without any consideration of two sources of uncertainties, and the second one to valuea compound rainbow option is rather complicated, but with the incorporation of themarket and technical uncertainty (unrelated). And the value of the project is found tobe much larger by using first valuation method. Compared with the traditional NPVmethod, this method generates a value 7 to 8 times the original one. The secondvaluation method, the more accurate one, has increased the NPV from $13.98 millionto $49.05 million, with a $35.07 million option value. This result is quite influencingfor the investment decision concerning further financing, although is constrained byits limitations and therefore accuracy. In all, the use of real option valuation approachcould increase the value of pharmaceutical R&D investment, but the use of thesuitable model is vital to derive a correct option value.Although the advantages of real options approach is rather obvious, it does notnecessarily mean that real option valuation methods is a substitute to NPV or DCFmethods. DCF is useful for safe cash flows, where there is less uncertainty, and it canbe viewed as the basis for real options valuation method. Howell (2001) confirmedthat by arguing that real options approaches cannot be treated as independent fromother features of the organization, especially the value of flexibility have to be setagainst costs arising from possible increased requirements for information productionand management control. And, if relevant information is not produced and motivationissues with respect to the exercise of flexibility are not addressed, evaluatinginvestment opportunities using real options techniques has the potential to bepositively misleading. Furthermore, real options valuation method could beconsidered as supplement to the traditional NPV valuation approaches, and offers abetter way of capturing the value of flexibility when uncertainty is large.Page | 69

Real Options analysis may be still under developed. But within the next few years,one important trend appearing in the world would be the rapid migration of existingfinancial option skills and models for use on real options (Howell, 2001). Brennan &Trigeorgis (2000): ―W here once the payback criterion reigned suprem e, ...discountedcash flow techniques … gradually gained acceptance and now tend to have pride ofplace*; as yet, only a few corporations are beginning to employ the real optionsparadigm that is derived from the classical financial option pricing paradigm ofBlack-S cho les and M erton.‖Page | 70

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