Application of Real Options Valuation to R&D Investments in Pharmaceutical Companies

This paper provides an insight into the application of real option valuation method to R&D projects in pharmaceutical companies. As one of the most important corporate finance decision-making methods, real option valuation method has been introduced in the last two decades. By applying option valuation methods, real option valuation is a useful tool to company managers. R&D investments in pharmaceutical companies are subject to considerable uncertainty, which may involve possibilities (i.e. Options). Options create value when the future is uncertain, and they support management to draw the highest possible value from an investment. After a careful review of the literature, including the definition and types of real options, its advantages over traditional valuation method and fundamentals of option pricing model, the general application of these theories to R&D investments in pharmaceutical industry is analysed. A case study of Davanrik at Merck & Co. is introduced to illustrate a situation in a real world context. Several option pricing methods can be used for a real options valuation, but binomial trees valuation method is chosen, as it could be more suitable model for valuing investment with high uncertainty, like pharmaceutical R&D s, especially for this complex compound rainbow option. The use of two different valuation methods provides two different option values, which shows the importance of choosing a correct valuation method. In all, the use of real option valuation approach could increase the value of pharmaceutical R&D investment, and the binomial trees approach is capable for valuing investments with high uncertainty like in this context