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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
Page 1 and 2: APPLICATION OF REAL OPTIONS VALUATI
Page 3 and 4: Table of ContentsAbstract .........
Page 5 and 6: List of TablesTable 5.1: Value of O
Page 7 and 8: Chapter One— IntroductionAs one o
Page 9 and 10: Then, in Chapter 4, the case study
Page 11 and 12: and we will have the right to take
Page 13 and 14: project, to get its salvage value,
Page 15 and 16: The option to switch:If assets have
Page 17 and 18: 2.2 Advantages of Real Option Valua
Page 19 and 20: In the case of pharmaceutical R&D,
Page 21 and 22: delayed in time. Undertaking one pr
Page 23 and 24: Figure 2.2: Advantages and disadvan
Page 25 and 26: smallest possible payoff of zero, w
Page 27 and 28: options applications is the binomia
Page 29 and 30: t: years to expirationr: annual ris
Page 31 and 32: Chapter Three— Apply Real options
Page 33: on Howell et al (2001).3.1.1 Precli
Page 37 and 38: Figure 3.3: Comparison of a call op
Page 39 and 40: applying the principals of activity
Page 41 and 42: that has occurred in the past. Depe
Page 43 and 44: Chapter Four— Case StudyFor this
Page 45 and 46: 4.3 DavanrikLAB Pharmaceuticals ori
Page 47 and 48: efficacious for depression only, a
Page 49 and 50: Chapter Five— Case Study Analysis
Page 51 and 52: figure below:Figure 5.3: NPV of Dav
Page 53 and 54: Merck & Co (10%), which gives $2338
Page 55 and 56: approval and other issues. Therefor
Page 57 and 58: of $345m at year 0 (which is $672.3
Page 59 and 60: project turns out to be unprofitabl
Page 61 and 62: these three options, the risk-free
Page 63 and 64: ewrite as, noting all the costs (in
Page 65 and 66: Figure 5.10: Valuation of Option A
Page 67 and 68: Figure 5.12: Valuation of Option A
Page 69 and 70: Figure 5.13 Valuation of Compound r
Page 71 and 72: $ in millionmillion to $113.97 mill
Page 73 and 74: Chapter Six— Limitations and conc
Page 75 and 76: discovery projects, arrives in a di
Page 77 and 78: References1. Amram M & Kulatilaka N
Page 79 and 80: 31/08/2006, available at: http://ho
Page 81 and 82: 46. T rigeorgis L . (1995), ―M et

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