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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
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 and 52: figure below:Figure 5.3: NPV of Dav
Page 53: Merck & Co (10%), which gives $2338
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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