Revenues from the pharmaceutical industry are forecast to grow by 7% per annum over the next seven years. To achieve this growth, current R&D business models need to be changed and a sophisticated approach to strategic portfolio management during R&D needs to be adopted.

Scrip Reports' Real Options Evaluation in Pharmaceutical R&D: A new approach to financial project evaluation takes the financial project evaluation principles covered in Financial Project Evaluation and Risk Analysis in Pharmaceutical Development further and applies them to the discovery, early research and preclinical stages of R&D.

Written by Kerstin Bode-Greuel, the author of the Financial Project Evaluation and Risk Analysis in Pharmaceutical Development, this report is the practical guide to managing an R&D portfolio using sophisticated risk analysis systems.

PUBLICATION: JANUARY 2000
REF: BS1038E
PAGES: 120+
PRICE: �1,250/$2,625/�300,000

CONTENTS
LIST OF TABLES
LIST OF FIGURES
ABOUT THE AUTHOR
EXECUTIVE SUMMARY

ES1 Real options in the pharmaceutical industry
ES2 Concept of real options evaluation
ES3 Applying real options evaluation in pharmaceutical R&D
ES4 Evaluating research projects

ABBREVIATIONS

CHAPTER 1 INTRODUCTION

CHAPTER 2 WHAT ARE REAL OPTIONS?
2.1 Introduction
2.2 Operating options
2.2.1 Option to defer
2.2.1.1 Case study
2.2.2 Option to abandon
2.2.3 Option to switch
2.2.3.1 Case study
2.2.4 Option to adapt operating scale
2.2.5 Option to improve
2.3 Strategic ('growth') options
2.3.1 Strategic options in research
2.3.2 Strategic options in development
2.4 Options associated with strategic acquisitions
2.5 Conclusions

CHAPTER 3 ADVANTAGES OF REAL OPTIONS EVALUATION COMPARED WITH TRADITIONAL METHODS
3.1 Introduction
3.2 First step: real options evaluation as a way of thinking
3.3 Second step: real options evaluation as a new algorithm for financial project evaluation
3.3.1 Comparison of different project evaluation methods using decision trees
3.3.1.1 Dynamic discounted cash flow analysis
3.3.1.2 Decision analysis
3.3.1.3 Option valuation
3.3.2 Black-Scholes algorithm
3.4 Conclusions

CHAPTER 4 FUNDAMENTALS OF FINANCIAL OPTION PRICING
4.1 Introduction
4.2 Terminology
4.3 Call options
4.4 Put options
4.5 Selling call and put options
4.6 Combinations of options
4.7 Determinants of option value
4.7.1 Five variables that determine the value of a call option
4.7.1.1 Exercise price
4.7.1.2 Time to expiration
4.7.1.3 Stock price
4.7.1.4 Risk-free interest rate
4.7.1.5 Volatility of the stock price
4.7.2 Factors determining put option value
4.8 Why discounted cashflows do not work for options
4.8.1 Constructing option equivalents by combining investments in stocks and borrowing
4.8.2 Risk-neutral method
4.8.3 Valuation of put options
4.9 Binomial option pricing method
4.10 Black-Scholes equation
4.11 Valuing compound options
4.12 Conclusions

CHAPTER 5 APPLYING REAL OPTIONS EVALUATION TO PHARMACEUTICAL R&D
5.1 Real options evaluation in the natural resource and commodities industries
5.2 Real options evaluation in the pharmaceutical industry
5.2.1 Five variables that determine the value of financial options - analogies to real options in pharmaceutical R&D
5.2.1.1 Exercise price
5.2.1.2 Time to expiration
5.2.1.3 Stock price: current value of the underlying asset
5.2.1.4 Volatility of the value of the underlying asset
5.2.1.5 Determination of the volatility parameter
5.2.1.6 Risk-free interest rate
5.2.1.7 Concluding remarks
5.3 Applying real options evaluation in the pharmaceutical industry
5.3.1 Using real options evaluation as a complement to NPV
5.3.2 Real options evaluation as a substitute to NPV
5.3.2.1 The asset to be evaluated is a marketed product
5.3.2.2 A marketed 'twin' asset can be identified that has a similar risk profile as the asset to be evaluated
5.3.3 Suggested applications of real options evaluation as a complement to NPV ('augmented NPV')
5.3.4 Suggested applications of real options evaluation as a substitute to NPV ('option pricing')
5.4 What makes real options evaluation different from decision analysis?
5.5 Conclusions

CHAPTER 6 REAL OPTIONS EVALUATION IN RESEARCH: CASE STUDIES
6.1 Applying real options evaluation as a complement to NPV
6.2 Applying real options evaluation as a substitute to NPV (Black-Scholes model)
6.3 Case study 1: Evaluating and prioritising research projects - applying the augmented NPV algorithm
6.3.1 Project 1: Serotonin-1A receptor agonists/serotonin-2 receptor antagonists for the treatment of stroke and head trauma
6.3.2 Project 2: L-type calcium channel antagonists with antidepressive and antioxidative properties for the treatment of dementia
6.3.3 Project 3: Search for CNS-selective T-type calcium channel modulators
6.3.4 Evaluation of the projects along qualitative and semi-quantitative parameters
6.3.5 Financial evaluation of the three research projects
6.3.6 Strategic expansion options as sources of additional value
6.4 Case study 2: Using the Black-Scholes algorithm to evaluate a research project
6.5 Real options evaluation in research: concluding remarks
6.6 Conclusions
6.6.1 Real options evaluation as a complement to NPV (augmented NPV)
6.6.2 Real options evaluation as a substitute to NPV (Black-Scholes model)

CHAPTER 7 REAL OPTIONS EVALUATION IN MANUFACTURING
7.1 Case study 1: Supporting the 'make-versus-buy' decision in the development of a new formulation
7.2 Case study 2: Evaluating the option to expand capacity in production
7.3 Conclusions

REFERENCES

LIST OF TABLES
Table 4.1 Prices of call options on BestPharma stock in April 1999, with the stock price (S) being $74 per share at that time
Table 4.2 Payoff of the call option on BestPharma stock at expiration in July
Table 4.3 Prices of put options on BestPharma stock in April 1999, with the stock price (S) being $74 per share at that time
Table 4.4 Payoff of the put option on BestPharma stock at expiration in July
Table 4.5 Payoff to the seller of BestPharma call options at expiration in July
Table 4.6 Payoff to the seller of BestPharma put options at expiration in July
Table 4.7 Combinations of options and shares: strategies at expiration
Table 4.8 Arbitrage profit if the value of an American call was below its lower bound
Table 4.9 Payoffs from the levered investment
Table 4.10 Payoffs from the levered investment (put option)

Table 5.1 Comparison of a call option with a lease on an undeveloped oil reserve
Table 5.2 Comparison of a call option with an investment in a new production plant
Table 5.3 Comparison of a call option with an investment in an R&D project
Table 5.4 Deriving volatility from historical data

Table 6.1 Qualitative scores and estimated market parameters characterising the three suggested projects
Table 6.2 Data sheet of the serotonin project
Table 6.3 Data sheet of the L-type Ca channel project
Table 6.4 Data sheet of the T-type Ca channel project

LIST OF FIGURES
Figure 1.1 Estimated value of growth options as a fraction of selected companies' equity value

Figure 2.1 Examples of operating options
Figure 2.2 Risk structure of a development project for the indication diabetic neuropathy
Figure 2.3 Expected project NPV if the project were started immediately
Figure 2.4 Improved risk structure of BP1999 after obtaining additional pharmacological information
Figure 2.5 Expected NPV of BP1999 after waiting for the results of additional pharmacological studies
Figure 2.6 Traditional NPV considers two scenarios
Figure 2.7 Inclusion of the abandonment options increases the project's NPV considerably
Figure 2.8 Option to improve by adapting the development plan to changing conditions
Figure 2.9 Strategic options in research
Figure 2.10 Strategic options in development

Figure 3.1 Comparison of three project evaluation methods using decision trees
Figure 3.2 Valuation of a project in the presence of a put option
Figure 3.3 Value of the option using traditional decision tree analysis
Figure 3.4 Value of the put option using real options analysis
Figure 3.5 Advantages and disadvantages of the three methods that use decision trees for dynamic cash flow analysis

Figure 4.1 Relationship between the value of a call option and value of stock from the perspective of the owner
Figure 4.2 Relationship between the value of a put option and value of stock from the perspective of the owner
Figure 4.3 Relationship between the value of a call option and value of stock from the perspective of the seller
Figure 4.4 Relationship between the value of a put option and value of stock from the perspective of the seller
Figure 4.5 Value of holding a put and a share in combination
Figure 4.6 Upper and lower bounds of call option value
Figure 4.7 Value of the call as a function of the stock price
Figure 4.8 Options will have value as long as there is time left until expiration
Figure 4.9 Value of a call on a stock depends on the volatility of stock price
Figure 4.10 The payoff of a call option on a highly volatile stock (B) is higher than the payoff on a less volatile stock (A)
Figure 4.11 The effect of the five variables on call versus put option values
Figure 4.12 Binomial option pricing: tree for the stock over two periods
Figure 4.13 Binomial option pricing: tree for the call option over two periods
Figure 4.14 Value of the call option

Figure 5.1 Determinants of the time to expiration in pharmaceutical R&D
Figure 5.2 Determinants of asset value in pharmaceutical R&D
Figure 5.3 Market ('exogenous') risk in the pharmaceutical industry
Figure 5.4 Real options evaluation as a complement to NPV - modelling risks and options in decision trees
Figure 5.5 Evaluating research projects applying the augmented NPV algorithm
Figure 5.6 Evaluating a pioneer venture
Figure 5.7 Evaluating a drug development project as a compound option using a continuous-time model
Figure 5.8 A jump model for valuing start-up companies and early research projects
Figure 5.9 A simplified option pricing model
Figure 5.10 Deriving investment rules from the position in the option space

Figure 6.1 Suggested financial models for the evaluation of research projects
Figure 6.2 Qualitative portfolio matrix used to support the prioritisation of research projects
Figure 6.3 Schematic decision tree of the serotonin project focusing on the project's risk architecture and abandonment options
Figure 6.4 Schematic decision tree of the L-type Ca channel project focusing on the project's risk architecture and abandonment options
Figure 6.5 Schematic decision tree of the T-type Ca channel project focusing on the project's risk architecture and abandonment options
Figure 6.6 Additional development opportunities as strategic expansion options
Figure 6.7 The serotonin project: strategic expansion options
Figure 6.8 The T-type Ca channel project: strategic expansion options
Figure 6.9 The Black-Scholes model: sensitivity analysis

Figure 7.1 Risk structure of the project if conducted in-house
Figure 7.2 Costs and revenues of the project
Figure 7.3 Risk structure of the project if performed by the contract institute
Figure 7.4 Augmented NPV of the in-house alternative
Figure 7.5 Augmented NPV of the outsourcing alternative
Figure 7.6 Potential future value of the marketed product without the option to expand production, taking into account market risks
Figure 7.7 Potential future value of the product with the option to expand
Figure 7.8 Present value of the product in the presence of the option
Figure 7.9 Present value of the product in the absence of the option
Figure 7.10 Present value of the product including the building's resale value

• Order this report.
• Request a catalogue.

© PJB Publications Ltd. 2000 All rights reserved.