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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
© Peter-Jan Engelen
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
© Peter-Jan Engelen
Slide nr.2
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.
© Peter-Jan Engelen
Slide nr.3
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
© Peter-Jan Engelen
Slide nr.4
Typical example of a growth option
I
large project
success
FOCF
Pilot project
start
Follow-up project?
t
T
failure
typical: NPV < 0
Real option value (ROV)
Project’s value = NPV(pilot) + ROV (follow-up)  if >0, then invest
© Peter-Jan Engelen
Slide nr.5
Extending the growth option
Growth option
Extension to multiple growth options
Sequential option
Application to a ‘regulated’ sequential option
Sequential drug development option
© Peter-Jan Engelen
Slide nr.6
The drug approval process
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 PostMarketing Testing
years
0
3
7
10
14
© Peter-Jan Engelen
Slide nr.7
Opening the R&D black box
© Peter-Jan Engelen
commercialisation
approval by
government
clinical test phase 3
clinical test phase 2
clinical test phase 1
pre-clinical test phase
Development of a new drug
success
NPV1
success
failure
NPV2
success
failure
success
failure
success
failure
success
failure
fundamental
research
failure
© Peter-Jan Engelen
Slide nr.9
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.
© Peter-Jan Engelen
Slide nr.10
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
© Peter-Jan Engelen
Slide nr.11
Case-study
Xandee Biochemical, Ltd.
© Peter-Jan Engelen
Its research and product portfolio
preclinical
clinical I
clinical II
clinical III
FDA approval
commercialization
INS-84
JR-32
FR-242
DIVE-4
MF-164
interim products
MV of product portfolio is the sum of:
•assets in place (interim products)
•unexercised compound growth options (pipeline)
© Peter-Jan Engelen
Slide nr.13
Valuation of R&D and product portfolio
Product
INS-84
Phase
Preclinical
Valuation model
5-fold compound option model
JR-32
Preclinical
5-fold compound option model
FR-242
Clinical I
4-fold compound option model
DIVE-4
Clinical III
2-fold compound option model
MF-164
Approval
1-fold compound option model
Interim
Commercialization
products
Discounted cash-flow model
© Peter-Jan Engelen
Slide nr.14
Details of its drug development pipeline
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
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.
© Peter-Jan Engelen
Slide nr.15
Details of its drug development pipeline
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
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.
© Peter-Jan Engelen
Slide nr.16
Decomposition of its market value
14%
39%
20%
Preclinical
Clinical I
Clinical III
Approval
Launched
12%
15%
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
© Peter-Jan Engelen
Slide nr.17
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)
© Peter-Jan Engelen
Slide nr.18
Contact information
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
© Peter-Jan Engelen
Slide nr.19