Portfolio Management in New Drug Development - Innovation and Marketing in the Pharmaceutical Industry - page 93

Fig. 3.4 Example decision trees (reproduced from Ding and Eliashberg 2002 )
limitations of the relatively “rigid” approach of NPV are exposed in the complex
and uncertain environment of drug development. There is considerable uncertainty
in all costs and revenue projections, and decisions are in fact made on a stage-by-
stage basis which provides considerably more managerial flexibility than NPV
allows for.
An extension to NPV which takes into account the probability distributions of
various parameters involves Monte Carlo analysis (Myerson 2004 ) to provide a dis-
tribution of possible NPVs that provides a better picture of worst, best, and expected
case scenarios compared to standard DCF analysis. However, to model the phased
decision-making process, methods such as real options pricing or decision trees
need to be used.
While the terms “real options” and “decision trees” are sometimes used inter-
changeably in practice, they represent different approaches rooted in fundamentally
distinct methodologies. Decision trees originate from the decision analysis litera-
ture and allow the specification of conditional probabilities of events depending on
staged decisions. The payoffs are calculated from an internal perspective of the firm
or decision maker. In Fig. 3.4 , we reproduce two example decision trees in Ding and
Eliashberg ( 2002 ). 4 The first tree shows a single-stage decision, while the second
4 Another relevant example of a drug development decision tree is found in Loch and Bode-Greuel
( 2001 ).