Principles of Corporate Finance_ 12th Edition

Chapter 22 Real Options 587

bre44380_ch22_573-596.indd 587 09/30/15 12:08 PM

22-5 Investment in Pharmaceutical R&D

An investment in research and development (R&D) is really an investment in real options.
When your research engineers invent a better mousetrap, they hand you an option to manufac-
ture and sell it. New and improved mousetraps can be engineering triumphs but commercial
failures. You will make the investment to manufacture and launch the better mousetrap only if
the PV of expected cash inflows is greater than the required investment.
The pharmaceutical industry spends massive amounts for R&D to develop options to
produce and sell new drugs. We described pharmaceutical R&D in Example 10.2 and in Fig-
ure 10.7, which is a simplified decision tree. After you have reviewed that example and figure,
take a look at Figure 22.8, which recasts the decision tree as a real option.
The drug candidate in Figure 22.8 requires an immediate investment of $18 million. That
investment buys a real option to invest $130 million at year 2 to pay for phase III trials and
costs incurred during the prelaunch period. Of course the real option exists only if phase II
trials are successful. There is a 56% probability of failure. So after we value the real option,
we will have to multiply its value by the 44% probability of success.
The exercise price of the real option is $130 million. The underlying asset is the PV of the
drug, assuming that it passes phase II successfully. Figure 10.6 forecasts the expected PV of
the drug at launch at $350 million in year 5. We multiply this value by .8, because the decision
whether to exercise the option must be taken in year 2, before the company knows whether the
drug will succeed or fail in phase III and prelaunch. Then we must discount this value back to
year 0, because the Black–Scholes formula calls for the value of the underlying asset on the
date when the option is valued. The cost of capital is 9.6%, so the PV today is

PV at year 0, assuming success in phase II = .8 × 350/(1.096)^5 = 177, or $177 million

◗ FIGURE 22.8 The decision tree from Figure 10.7 recast as a real option. If phase II trials

are successful, the company has a real call option to invest $130 million. If the option is exercised,

the company gets an 80% chance of launching an approved drug. The PV of the drug, which is

forecasted at $350 million in year 5, is the underlying asset for the call option.

Phase II trials, 2 years Phase III trials and prelaunch, 3 years

Succeed

Fail

PV 5 0

PV at launch,

year 5

(Forecast 5 $350)

Underlying

asset

Fail

PV 5 0

56%

44%

Succeed

Invest 18?

20%

Invest $130

at year 2

80%

Call

option

(Exercise of the rolling option means that the airline joins the end of the queue.) Airbus also
offers a purchase option that includes the right to switch from delivery of an A320 to an
A319, a somewhat smaller plane.