Biomedical Engineering Reference
In-Depth Information
tree shows how a phased approach can account for probabilities of success or failure
along with the expected final payoff. The decision which maximizes expected value
or expected utility can then be identified. This approach can be combined with
Monte Carlo analysis to perform sensitivity analysis with respect to uncertain
parameters.
Real options theory originates from the financial economics literature and defines
value in terms of what the asset would be worth in the marketplace, not just based
on its worth to the decision maker, which is a point of distinction from decision
analysis (Smith
1999
). Based on Black and Scholes' (
1973
) seminal paper on pric-
ing call and put options, real options theory applies the principle to valuing manage-
rial flexibility inherent in drug development projects based on the assumption that
asset value over time can be modeled as a continuous-time stochastic process (Tan
et al.
2010
).
The key equation from Black and Scholes (
1973
) defines the value of an option
(
w
) which can only be exercised at maturity date
t
*
for a given current asset price (
x
)
and time (
t
) given exercise price
c
, and variance rate of the return on the asset (
v
2
) :
(
)
*
()
=
()
−
rt t
−
()
wxt xd e
,
Φ
Φ
d
1
2
where
x
c
++
1
2
x
c
+−
1
2
(
)
(
)
2
*
2
*
ln
r vt
−
t
ln
r
vvt
−
t
d
=
and
d
=
1
2
*
*
vt t
−
vt t
−
However, as Smith (
1999
) points out, the difficulty in solving such models when
options can be exercised at any time focuses real options analyses on the evolution
of a small number of stochastic factors. Smith (
1999
) contrasts the “dynamic com-
plexity” of real options models with the “detail complexity” that decision trees can
incorporate. In principle therefore, real options theory helps the pharmaceutical
portfolio manager to factor in the potential upsides of a drug investment that may
not necessarily be predictable in advance. A well-known example to illustrate this
point is the development of Viagra
®
by Pfizer. Originally targeted at lowering blood
pressure, a chance finding that it had a side effect of treating erectile dysfunction
significantly boosted the drug's market potential. While not every drug may have
such an upside, factoring in managerial flexibility to change course often allows for
greater realism and firms have found options pricing to yield substantially higher
valuations than a DCF approach (Faulkner
1996
).
Loch and Bode-Greuel (
2001
) show that decision trees are equivalent to options
pricing for risks that can be priced in the financial markets and can also capture risks
that are not traded in financial markets. Thus, the downside of options pricing is the
requirement for complete financial markets. However, the principle of “real options”
whether modeled as a decision tree or options pricing problem brings more realism
to planning for phases of development.
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