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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
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 and 34: on Howell et al (2001).3.1.1 Precli
Page 35: approved.3.2 real options valuation
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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