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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
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 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: figure below:Figure 5.3: NPV of Dav
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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