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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