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their corresponding probabilities) could cause serious errors in option value. In all, theuse of real option valuation approach could increase the value of pharmaceutical R&Dinvestment, but the use of the suitable model is vital to derive a correct option value.Page | 66
Chapter Six— Limitations and conclusion6.1 limitations6.1.1 For Option BIn the valuation of this compound option, some rough assumptions have been made.Firstly, the estimation of volatility. It assumes no dividends have been paid during thetime of the options. And the assumption is rather simple, as is assumes same volatilityover the life period of the option B. This could be problematic in the real world, as thevolatility may not be know and may change over the life of the option, which couldmake the option valuation very complex. More importantly, the valuation methodused may not be the best suitable one for this case, and Monte Carlo Simulation maybe a better way to estimate the volatility. Due to time constraints, however, a simplervaluation method was used. Secondly, the assumption of salvage value. The salvagevalue of option B is assumed to be related to their value for each underlying assetvalue, and the estimation of salvage value did not incorporate issues like inflation.And finally, for this ten year option, a binomial tree of only 5 steps has been used. Allthese assumptions could affect the accuracy of the result.6.1.2 For Option AFirstly, volatility. As explained earlier in this chapter, the volatility for Option A couldbe simulated, but an assumption of 70% was made. Although the sensitivity analysisspecifically addressed the impact of the change of volatility on real option values, thiscould still be one of the factors that influence the accuracy of option valuation.Secondly, risk-free rate for option A is assumed to be a single one, for the sake ofPage | 67
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 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: $ in millionmillion to $113.97 mill
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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