Handling complex decisions in the development of new drugs in pharmaceutical firms
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Handling Complex Decisions in the Development of New Drugs in Pharmaceutical Firms. Cassimon, Engelen and Yordanov. FUR XII , LUISS, Roma , Italy, 22-26 June 2006. Valuation of pharma companies.

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Handling Complex Decisions in the Development of New Drugs in Pharmaceutical Firms

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Handling Complex Decisions in the Development of New Drugs in Pharmaceutical Firms

Cassimon, Engelen and Yordanov

FUR XII, LUISS, Roma, Italy, 22-26 June 2006


Valuation of pharma companies

  • Financial analysts typically split the value of a pharmaceutical company in three building blocks:

(i) existing marketed products;

(ii) new products in the mid to late stage of development (phase II and III of the clinical testing);

(iii) early R&D.

Valuation is problematic

with current models


Real option characteristics of projects

  • Financial option: right (not an obligation) to buy or sell a certain asset at specific moments at a predetermined price

  • What are real options?

    • Recognizing the project itself or certain components as options

    • A project is an option, whereby the company obtains the right to all future FOCFs the project generates, in exchange for a predetermined price (investment cost of the project)

  • Different types of real options

    • Growth options, options to delay, etc.


Real option approach to R&D

  • Benefits of real option approach compared to traditional models:

    • Can handle operational flexibility with respect to investment decisions

      • Abandonnement, delay or adjustment of projects, e.g. stop R&D of particular drug

    • Takes into account the strategic value of a project because of its interdependence with future projects

      • R&D give option to follow-up projects

      • Real option models are better suited to value R&D


I

large project

FOCF

success

Follow-up project?

Pilot project

start

t T

failure

Real option value (ROV)

typical: NPV < 0

Typical example of a growth option

Project’s value = NPV(pilot) + ROV (follow-up)  if >0, then invest


Extending the growth option

Growth option

Extension to multiple growth options

Sequential option

Application to a ‘regulated’ sequential option

Sequential drug development option


Discovery

(2-10 years)

Preclinical Testing

Laboratory and animal testing

Clinical Phase I

20-80 healthy volunteers used to

determine safety and dosage

Clinical Phase II

100-300 patient volunteers used to

look for efficacy and side effects

Clinical Phase III

1000-5000 patient volunteers used to

monitor adverse reactions to long-term use

FDA Approval

Additional Post-

Marketing Testing

The drug approval process

years

3

7

10

14

0


Opening the R&D black box


fundamental

research

Development of a new drug

commercialisation

approval by

government

NPV1

success

clinical test phase 3

clinical test phase 2

success

failure

NPV2

success

clinical test phase 1

failure

pre-clinical test phase

success

failure

success

failure

success

failure

failure


R&D on new drug as a chain of options

(a)first option– decision to start preclinical phase;

(b)second option– decision to start first clinical trial phase;

(c)third option –decision to start second clinical trial phase;

(d)fourth option– decision to start third clinical trial phase;

(e) fifth option–decision to file for regulatory approval;

(f) sixth option – decision to launch the new drug on the market.


How to value this chain of real options?

  • Chain of real options in drug development can be seen as a case of compound option models

  • Geske (1979) – 2-fold compound option (option on an option)

  • R&D of new drug – 6-fold compound option

  • We use the extended n-fold compound option model of Cassimon et al. (2004)

  • Programmed in Matlab


Case-study

Xandee Biochemical, Ltd.


INS-84

JR-32

FR-242

DIVE-4

MF-164

interim products

Its research and product portfolio

commerciali-

zation

preclinical

clinical I

clinical II

clinical III

FDA approval

  • MV of product portfolio is the sum of:

    • assets in place (interim products)

    • unexercised compound growth options (pipeline)


Valuation of R&D and product portfolio


Option

ti

Ki

V

n-fold COV

Panel A – Product JR-32 ( = 0.81; wacc = 23%) – Preclinical phase

1

1.5

8.3

2

2.5

29.1

3

4

55.7

4

6.5

14.1

5

8

50.6

81.7

30.4

Panel B – Product INS-84 ( = 0.64; wacc = 18%) – Preclinical phase

1

3

15.8

2

4

48.5

3

6

96.4

4

8.5

25.3

5

10.5

107.2

72.7

15.6

Details of its drug development pipeline

Legend: ti is the maturity date for the compound call option Ci (expressed in years), Ki is the exercise price for the

compound call option Ci,; V is the current value of the underlying project;  is the instantaneous standard deviation

of the project return; wacc is the risk-adjusted discount rate of the project and COV is the compound option value

based on the corresponding n-fold compound option model. Ki,, V, I and COV in million USD.


Panel C – Product FR-242 ( = 0.78; wacc = 21%) – Clinical I phase

1

0.5

10.2

2

2

33.7

3

5

8.3

4

6.75

60.0

65.8

19.4

Panel D – Product DIVE-4 ( =0.63; wacc = 18%) – Clinical III phase

1

2

8.5

2

3.5

29.4

61.1

33.4

Panel E – Product MF-164 ( = 0.46; wacc = 15%) – Approval phase

1

1

25.2

43.8

16.2

Details of its drug development pipeline

Legend: ti is the maturity date for the compound call option Ci (expressed in years), Ki is the exercise price for the

compound call option Ci,; V is the current value of the underlying project;  is the instantaneous standard deviation

of the project return; wacc is the risk-adjusted discount rate of the project and COV is the compound option value

based on the corresponding n-fold compound option model. Ki,, V, I and COV in million USD.


Decomposition of its market value

  • 39% of its MV comes from early stage R&D

  • 86% of its MV comes from drug development pipeline

  • Only 14% of its MV comes from existing products


Conclusions

  • Product portfolio of a pharmaceutical firm consists of exercised (assets in place) and unexercised (growth opportunity) real options

  • Real option component can be valued using generalised n-fold compound option models

  • Benefits:

    • possible to decompose MV of product portfolio in different components linked to specific phases of drug development process

    • Better insight in different value blocks of pharmaceutical firm (over the full range of phases of drug development)


If you have …

comments or suggestions,

proposals for research collaboration, or

proposals for consulting work,

… please contact us at:

[email protected]

Peter-Jan Engelen

Utrecht University, Vredenburg 138

3511BG Utrecht, Netherlands

Contact information


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