Application of Real Option Analysis to Pharmaceutical R&D Project

Research and development (R&D) in pharmaceutical sector are characterized by long planning horizon, high uncertainty and irreversibility. A critical component in drug development is determining the financial value of the potential compound in the light of the substantial technical and economic uncertainty (Rogers et al, 2005). Given the well-know shortcomings of DCF, real option approach is considered to capture the substantial flexibility and value of strategy involve in the R&D project. Considerable efforts have been made in modeling of real R&D options given uncertainty and managerial flexibility as the key consideration. Case study in this paper confirms the superiority of ROA in capturing the value of operating options embedded in the drug process These value have been reflected in the higher project value obtained by treating three compulsory clinical phases as a compound rainbow option than the one obtained from augmented NPV. The implication is that optimal decision can be made by management according to the different result of ROA whenever new information comes over the life of the R&D. Binominal pricing model is considered as a appropriate method to capture the characteristics of compound rainbow options.