Incorporating technical risk in compound real option models to value a pharmaceutical R&D licensing opportunity

• Published in: Research policy 2011-11, Vol.40 (9), p.1200-1216
• Main Authors: Cassimon, D., De Backer, M., Engelen, P.J., Van Wouwe, M., Yordanov, V.
• Format: Article
• Language: English
• Subjects: Case studies; Case study; Commerce; Compound option model; Licensing; Medical treatment; Multinational enterprises; Pharmaceutical industry; Pharmaceutical R&D; R&D; Real options; Real options analysis; Research & development; Research and development; Risk; Studies; Technical risk; Valuation
• ISSN: 0048-7333; 1873-7625
• DOI: 10.1016/j.respol.2011.05.020

► Explicitly incorporates technical risk in a generalized n-fold compound option model. ► Offer a closed-form solution for the valuation of a new drug development with commercial and technical risk. ► Illustrates the theoretical model with a real-life project of a major pharmaceutical multinational. The valuation of multi-staged pharmaceutical R&D can be interpreted as a chain of real options. In valuing these compound option models, a crucial problem is how to deal with the different types of risk. Previous models, such as Cassimon et al. (2004), offer a closed-form solution for the valuation of a new drug development using a generalized n-fold compound option model, but implicitly bundle both commercial and technical risk in one risk measure. We extend this model by explicitly incorporating technical risk, while still preserving the closed-form solution of the model. As such, this extended model is better suited to handle real-life valuation cases in the pharmaceutical industry. We document the theoretical model with a real-life project of a major pharmaceutical multinational.