The impact of external market conditions on R&D valuation

Traditional real options models regard the idiosyncratic risk of a project as the main value driver. Beyond the specific risks embedded in the project, i.e., both its technical and idiosyncratic risk, our model captures the interactions among different market, economic and social forces and their impact on R&D project valuation. Using Fourier series, our model aggregates external forces that play relevant roles in the process that determines the cash flow structure. Consequently, the posited model provides managers and policy makers with a powerful yet flexible tool to stress test several economic scenarios under which the project could develop. In a practical case, we apply our novel model and methodology to the valuation of a pharmaceutical R&D project and examine the impact of external forces on the optimal time to launch the project. The real options approach also allows for the possibility of optimally abandoning a project before completion whenever the investment cost exceeds the expected net cash flow stream after considering the impact of market conditions