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List of FiguresFigure 2.1: Comparison of three project valuation methods using decision trees .... 16Figure 2.2: Advantages and disadvantages of the three methods that use decisiontrees for dynamic cash flow analysis ..................................................................... 17Figure 3.1: Stages in Drug Development of a typical project 1 .............................. 26Figure 3.2: Stages in Drug Development of a typical project 2 .............................. 26Figure 3.3: Comparison of a call option with an investment a new production plant............................................................................................................................. 31Figure 3.4: analogies between stock options and real options in R&D project........ 32Figure 5.1: R&D Process of Davanrik at Merck & Co. .......................................... 43Figure 5.2: NPV of Davanrik at Merck & Co. 1..................................................... 44Figure 5.3: NPV of Davanrik at Merck & Co. 2..................................................... 45Figure 5.4: Volatility estimation for option from year7 to year 17 .......................... 48Figure 5.5: Valuation of Option B (underlying: Depression) .................................. 49Figure 5.6: Valuation of Option B (underlying: Weight loss) ................................. 50Figure 5.7: Valuation of Option B (underlying: Both) ............................................ 51Figure 5.8: Volatility of Option A (Year 0-7 ........................................................... 54Figure 5.9: new flow chart of the Davanrik R&D process (real time value) ........... 57Figure 5.10: Valuation of Option A (underlying: Depression) ................................ 59Figure 5.11: Valuation of Option A (underlying: Weight Loss)............................... 60Figure 5.12: Valuation of Option A (underlying: Both) .......................................... 61Figure 5.13: Valuation of Compound rainbow option ............................................ 63Figure 5.14: Sensitivity Analysis for two valuation methods.................................. 65v
Chapter One— IntroductionAs one of the most important corporate finance decision-making methods, real optionvaluation method has been introduced in the last two decades. By applying optionvaluation methods, real option valuation is a useful tool to company managers.M anagers o f firm s m ay not necessarily use the term ―real options‖ to describe theseopportunities, they m ay use the term ―strategic value‖ or ―intangible advantages‖, andthese sometimes become the key in their decision-making process.This paper is the application of real option valuation method to R&D projects inpharmaceutical companies. This paper is motivated by the need of more accuratevaluations for high intensive Research and Development (R&D) projects. An accurateproject valuation is crucial for the survival of companies. Especially for those sectorsthat have R&D intensive projects with high uncertainty, being able to compute a goodapproximation of the value of the project is critical for the decision-making process.The fact that managers can decide what action to take at different points during thelife of the project has proven to be quite valuable. The value of these options can besuch that makes the difference between entering or not in an investment. The RealOptions Approach attempts to value projects by considering the value of being able todecide among several strategic options. Especially when the value of a project ishighly dependent on the level of flexibility that it allows, the real option methodologyshould be used. Otherwise, the valuation is not accurate because the project isundervalued.Page | 1
Page 1 and 2: APPLICATION OF REAL OPTIONS VALUATI
Page 3 and 4: Table of ContentsAbstract .........
Page 5: List of TablesTable 5.1: Value of 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 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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