Application Of Real Options Valuation To Durg R&D Investments

The drug development process is full of irreversibility, uncertainty and flexibility whichimplies the potential option value in drug valuation. However，the traditional investmentevaluation methods, like NPV and Comparables, can underestimate the project value byoverlooking some uncertainties and flexibility, thus leading to high-risk and high-pay offprojects that are rejected. This paper details the process of new drug research anddevelopment, and studies characteristics of R&D. Meanwhile, the pros and cons of traditionalinvestment decision-making methods versus real option methods are studied. Given the highrisks and uncertainties in drug R&D projects, this paper introduces a compound real optionvaluation model. The paper describes and illustrates this new approach with an application toa R&D project of a pharmaceutical company. The key factors in the valuation are spotted andintroduced.Several option pricing methods can be used for a real options valuation, but binomialtrees valuation method best fits the purpose as it is both intuitive and easy to understand. Itbest fits the valuation of investment with high technological and economic uncertainties, likepharmaceutical R&D investment. Through the recognition of intrinsic and built-in flexibilityvalue, this approach leads apparent value increment. The more flexible the project is, thegreater the value increment is. Considering the value of real options embedded in R&Dprojects will help managers make more informed financing decisions.