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simplicity. But the use of different risk-free rates could lead to more accurate result.Thirdly, the second valuation method is a simpler version of the quadranomialapproach. But due to time constraint, the present valuation method is used.6.2 ConclusionR&D investment in pharmaceutical companies like most real investments arecharacterized by a high level of future uncertainty, which influences the present valueof R&D projects is composed of technological and market uncertainties.The objective of this paper was to apply a richer decision-making tool, i.e. the realoption methodology for the valuation of multi-staged R&D projects. The paperhighlighted the main concept of real options, its common types, and the valuation ofreal options.A case study of Davanrik at Merck & Co. is used to illustrate the valuation of acomplex compound option, by using binomial tree method. Analysis of Davanrik‘sR&D process showed that at each stage managers have the possibility (i.e. right) tocontinue or to abandon the project in the case of technological failure and/orunfavorable market conditions. Option A (for the time period 0-7) and Option B (forthe time period 7-17) can be seen as a sequential compound option, while Option A isanother sequential compound, and Option B is an American put option assuming thatthe project can be abandoned at any time after the launch.The solutions by using binomial trees approach was applied to find the value of thiscompound option, as it was considered as the more appropriate to valuePharmaceutical R&D projects than other option pricing models like Black-Scholemodel. The reason is that this model accounts for both sources of uncertainty(technological and economic) and sequential nature of R&D projects. Furthermore, itwas identified that strategically important information changing the value ofPage | 68
discovery projects, arrives in a discontinuous way. This process is properlyapproximated by the binomial trees model.The solution of option value A is derived from two methods. The first one is simpler,without any consideration of two sources of uncertainties, and the second one to valuea compound rainbow option is rather complicated, but with the incorporation of themarket and technical uncertainty (unrelated). And the value of the project is found tobe much larger by using first valuation method. Compared with the traditional NPVmethod, this method generates a value 7 to 8 times the original one. The secondvaluation method, the more accurate one, has increased the NPV from $13.98 millionto $49.05 million, with a $35.07 million option value. This result is quite influencingfor the investment decision concerning further financing, although is constrained byits limitations and therefore accuracy. In all, the use of real option valuation approachcould increase the value of pharmaceutical R&D investment, but the use of thesuitable model is vital to derive a correct option value.Although the advantages of real options approach is rather obvious, it does notnecessarily mean that real option valuation methods is a substitute to NPV or DCFmethods. DCF is useful for safe cash flows, where there is less uncertainty, and it canbe viewed as the basis for real options valuation method. Howell (2001) confirmedthat by arguing that real options approaches cannot be treated as independent fromother features of the organization, especially the value of flexibility have to be setagainst costs arising from possible increased requirements for information productionand management control. And, if relevant information is not produced and motivationissues with respect to the exercise of flexibility are not addressed, evaluatinginvestment opportunities using real options techniques has the potential to bepositively misleading. Furthermore, real options valuation method could beconsidered as supplement to the traditional NPV valuation approaches, and offers abetter way of capturing the value of flexibility when uncertainty is large.Page | 69
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 and 72: $ in millionmillion to $113.97 mill
Page 73: Chapter Six— Limitations and conc
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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