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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
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 and 36: approved.3.2 real options valuation
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: 4.3 DavanrikLAB Pharmaceuticals ori
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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