Project valuation in the pharmaceutical industry: a comparison of least‐squares Monte Carlo real option valuation and conventional approaches

Least‐squares Monte Carlo simulation (LSM) is a promising new technique for valuing real options that has received little or no attention in the pharmaceutical industry. This study demonstrates that LSM can handle complex valuation situations with multiple uncertainties and compounded American‐type options. The limited application of real option valuation (ROV) in the pharmaceutical industry is remarkable, given the importance of accurate project valuation in an industry that requires large investments in high‐risk projects with long pay‐back periods, which is furthermore suffering from ever‐increasing development costs and shrinking profit margins. The LSM model developed in this study is constructed as an extension of a discounted cash flow model that should be familiar to economists active in the pharmaceutical industry. A number of pharmaceutical projects have been evaluated using LSM ROV, binominal real option valuation and expected net present value techniques. The different results yielded by these methods are explained in terms of differences in risking assumptions and ability to capture the value of flexibility. The analysis provides a framework to introduce the basic concepts of real option pricing to a non‐specialist audience. The LSM model illustrates the potential for real‐life commercial assessment as the versatility of the technique allows for an easy customisation to specific business problems.     

R&D as an option on market introduction

Discounted cash flow methods for making R&D investment decisions cannot properly capture the option value in R&D. Since market and technology uncertainties change expectations about the viability of many new products, the value of projects is frequently adjusted during the R&D stages. Capturing the adjustment in expectations has an option value that may significantly differ from the Net Present Value of R&D projects. However, there are no historic time series for estimating the uncertainty of the value of R&D projects. As a result, the standard Black and Scholes model for financial option valuation needs to be adjusted. The aim of this paper is to report the application of a particular option pricing model for setting the budget of R&D projects. The option value of the model captures jumps or business shifts in market or technology conditions. The approach originates from applying current insight into the valuation of R&D projects to the field of multimedia research at Philips Corporate Research. This way, the gap between real option theory and R&D practice is further diminished.     

Optimal exploration investments under price and geological‐technical uncertainty: a real options model

This article develops a real options model for valuing natural resource exploration investments (e.g. oil or copper) when there is joint price and geological‐technical uncertainty. After a successful several‐stage exploration phase, there is a development investment and an extraction phase. All phases are optimized contingent on price and geological‐technical uncertainty.
Several real options are considered. There are flexible investment schedules for all exploration stages and a timing option for the development investment. Once the mine is developed, there are closure, opening and abandonment options for the extraction phase. Our model maintains a relatively simple valuation structure by collapsing price and geological‐technical uncertainty into a one‐factor model.
We apply the model to a copper exploration prospect and find that a significant fraction of total project value is due to the operational, development and exploration options available to project managers.     

Evaluation of a mining project under the joint effect of commodity price and exchange rate uncertainties using real options valuation

Cash flows generated by mining projects tend to be volatile and are extensively influenced by exogenous variables, notably commodity prices and exchange rates. The traditional discounted cash flow (DCF) method, which is normally used for economic feasibility studies and mining project evaluations, presents inconsistencies because the method fails to adequately address uncertainties and operational flexibilities and often ignores certain specific market conditions. Numerous studies have been carried out for mining project evaluations using the real options valuation (ROV) technique for assessing commodity price uncertainty, but there is no research on the combined effects of price and exchange rate uncertainties. Therefore, in order to assess the economic viability of a mining project more accurately, the commodity price and its inherent volatility, the exchange rate and its inherent volatility, and the correlation parameters between them have been incorporated into the model and used in the evaluation process. One of the interesting findings revealed in the study is that project values are overestimated if only commodity price uncertainty is considered in evaluating the project value instead of the joint effect of commodity price and exchange rate uncertainties. This new ROV technique will explore the opportunity to utilize an alternative methodology for approximating project values and to identify valuation opportunities to enhance economic gains or to mitigate economic losses, where the DCF valuation method does not.     

A BETTER UNDERSTANDING OF WHY NPV UNDERVALUES MANAGERIAL FLEXIBILITY

The Real Options paradigm addresses the valuation of managerial flexibility in capital budgeting. Despite the great strides achieved by researchers in this field, many financial analysts have chosen not to adopt this new paradigm due to a lack of comfort with the approach and the mathematical complexity of the valuation models. This article shows how some projects with real options can be valued using simple and familiar tools-discounting expected cash flows after adjusting the discount rate. Unless the discount rate is adjusted to account for the impact of real options on risk, a traditional net present value (NPV) analysis misses the value of flexibility. By narrowing the gulf between Real Options analysis and more familiar tools, the weighted average discount rate (WADR) approach introduced in this paper may help novices better understand die Real Options paradigm, which subsequently may gain the wider acceptance it deserves. Though the WADR approach is practical only for simple real options, comfort with the approach may encourage analysts to pursue more advanced and robust real option valuation techniques for more complex applications.     

Stochastic Oil Price Models: Comparison and Impact

A good investment decision-making process is one that is able to assess risk and uncertainty and manage them in a balanced manner. Literature on current oil and gas industry practice indicates that the modeling of uncertainty is largely restricted to reserves while production, cost, and oil price data are all single point deterministic values indicating certainty. The objective of this article is to explore the impact of three stochastic oil price models: geometric Brownian motion (GBM), mean reversion (MR) and mean reversion with jumps, on the uncertainty output of a project's net present value (NPV). Furthermore, it investigates the impact of varying the input parameters of the three stochastic oil price models. This article concludes that range in the project NPV values using the MR with jumps model is far greater than the MR and GBM models. In addition, if the decision is based on the mean value, then the GBM model is a good approximation if the current oil price is close to the long-term price. However, if the decision is based on the standard deviation, GBM does not provide a good approximation. Finally, uncertainty in the volatility of oil price has a significant impact only in the GBM model, but not on the MR or the MR with jumps models.     

An option pricing approach to the valuation of rubber and palm oil producers

Advances in the option pricing literature have important implications for more basic valuation problems. An option pricing approach to the valuation of risky firms can accommodate uncertainty about product market conditions and managerial decisions more readily than a discounted cash flow approach. This paper adapts the stock option pricing approach of Black and Scholes (1973) to the valuation of shares of rubber and palm oil producers. A case study assesses the power of an option-based model to predict market share prices of a rubber and palm oil producer listed on the Stock Exchange of Singapore.     

The Value of Employer-Sponsored Child Care to Employees

This article uses the contingent valuation method for calculating the value of employer-sponsored child care to employees. Like many environmental amenities, there may be a nonuse or existence value of working for a company that offers employer-sponsored child care (ESCC), as well as a use value to parents who have children in the center. We test this hypothesis using data from three firms, two of which have on-site child care. Our findings indicate that price is a determinant of willingness to pay for the continued existence or establishment of an on-site center. We find evidence of the existence value, even for employees without young children, and a greater valuation among recent hires than among longer-term employees.     

Dark Fiber Valuation

Valuation of dark fiber has recently generated controversy, sparked particularly by the large sums booked for swaps of dark fiber between companies. One of the issues raised is valuation: i.e., what is the value of an asset that generates no revenue now and may do so at some unknown point in the future but only after investment, in an uncertain business climate, and where prices are dropping? The picture is further complicated because the result of investing to bring the asset to market (i.e. lighting the fiber) changes the supply and demand conditions of the market itself and hence invalidates price predictions. A realistic and consistent valuation methodology is necessary for increasingly cautious companies, auditors, and investors. In this paper we describe such a valuation methodology for dark fibre based on real options. Publicly available bandwidth price services start to make this practical by providing market price information. For dark fibre valuation the real option to be valued are the lighting decisions. We specifically include the effect on the market of adding new capacity by using the price-elasticity of demand within the stochastic price process itself, conditional on lighting decisions. Prices are generally volatile and decreasing with time. The evolution of lighting costs and maintenance are included in the valuation. The real options technique used here is novel in that it combines economic and market factors explicitly with mathematical finance to arrive at a valuation and optimal decisions. We found that the optimal lighting riming and capacity decisions to depend on many of the factors included in the analysis with no simple triggers: the details really matter.     

生物制药项目价值评估方法研究

本文研究通过比较传统的净现值法、风险调整的净现值法以及实物期权法,研究在生物制药业项目开发阶段的价值评估的方法,说明风险调整的净现值法以及实物期权法是较好的研究生物制药项目价值评估的方法。     

Strategic planning: valuing and managing portfolios of real options

This article presents a value-based strategic planning framework suitable for valuing and managing portfolios of corporate real options. The proposed framework combines insights from strategic management theory with novel quantitative valuation tools from finance. Strategic planning is viewed as a process of actively developing and managing portfolios of corporate real options in the context of competitive interactions. As such, the expanded valuation framework recognizes that future growth opportunity value deriving from the firm's resources and capabilities must explicitly account for uncertainty, adaptability, and competitive responsiveness. The resulting expanded valuation framework is able to capture the value of the adaptive resources and capabilities that enable a firm to adapt and re-deploy assets, develop and exploit synergies, and gain competitive advantage via time-to-market and first- or second-mover advantages. We show how two basic metrics in this value-based framework, current profitability of assets in place and future growth option value, can be obtained from financial market data and how they can be used in active portfolio planning.     

A Dynamic Model of Auctions with Buy‐It‐Now: Theory and Evidence

In the ascending‐price auctions with Yahoo!‐type buy‐it‐now (BIN), we characterize and derive the closed‐form solution for the optimal bidding strategy of the bidders and the optimal BIN price of the seller when they are both risk‐averse. The seller is shown to be strictly better off with the BIN option, while the bidders are better off only when their valuation is high enough. The theory also implies that the expected transaction price is higher in an auction with an optimal BIN price than one without a BIN option. This prediction is confirmed by our data collected from Taiwan's Yahoo! auctions.     

从国际市场看油价对钻井成本的影响

近年来国际油价暴涨，油气企业效益普遍明显提高，对于目前国内已经改革重组的钻井行业来讲，也面临着诸多机遇和挑战。本文从国际钻井工程服务市场的现状出发，初步研究了钻井成本随油价变化的规律，并以斯伦贝谢（Schlumberger）、哈里伯顿（Halliburton）等服务公司效益随油价的变化情况为例，探讨了油价对国际钻井市场的影响，期望为钻井行业决策提供一定参考。     

Analyzing operational real options in metal mining investments with a system dynamic model

This article presents a detailed system dynamic (SD) model of a metal mining investment that is usable in ex-ante profitability and operations management analysis. We show how the SD model can be used to analyze the profitability effect of three operational real options: the option to temporarily close production, the option to abandon production, and the option to increase production through cutoff grade change. The SD model allows for intuitive modeling of the multiple interactive real options and arriving at results that are difficult, or impossible, to reach with commonly used spreadsheet software. We also analyze the effect of mining project debt ratio to the project value and show that correctly choosing the debt ratio affects project profitability. The effect on the project value of using three different future metal price scenarios with two different stochastic processes is illustrated to highlight the importance of correct process selection in modeling future metal price paths. A realistic case of a high-cost nickel (Ni) metal mine is used as a basis for the presented numerical illustration of the model.     

An Arbitrage-Free Estimate of Prepayment Option Prices in Fixed-Rate GNMA Mortgage-Backed Securities

In an efficient market, the no-arbitrage condition implies that the price difference between any two assets must be the market value of all differences in their cash flows. We use this logic to deduce the price of the prepayment option embedded in fixed-rate Government National Mortgage Association (GNMA) mortgage-backed securities. The option price equals the difference between an observed GNMA price and the cost of a synthetic, nonprepayable GNMA constructed from the least expensive portfolio of Treasury securities that exactly replicates the promised GNMA cash flow stream, assuming prepayment is precluded. We regress the option prices on variables found significant in previous prepayment studies, finding that five key regressors explain more than 90% of the prepayment option value in pooled time-series cross-sectional analysis. We also show that the time value of the prepayment option calculated by our method displays a pattern similar to that produced by the Black-Scholes (1973) option pricing model. An additional empirical result is the existence of negative option prices and negative time value of the option prices. We attribute these to the fact that homeowners sometimes exercise their prepayment options when they are out-of-the-money, and to refinancing transaction costs. Our method is independent of assumptions regarding interest rate processes and the homeowner's prepayment behavior, and it provides a benchmark for testing theoretical prepayment models.     

Switch,Switch, Switch! A Regime-Switching Option-Based Model for Valuing a Tolling Agreement

This article proposes a real options valuation of a tolling contract using a combined switching option and volatility regime switching model. In a tolling-based transaction, the toller becomes the energy manager (but not the owner) of the power plant, having the option to switch it on or off to benefit from (mitigate) the upside (downside) potential related to frequent, jumpy fluctuations of power (and gas) prices. Value creation from such flexibility in managing the spark spread risk may be better captured by expanding the static NPV of the plant via exercise of a switching (compound) option having the plant itself as an underlying two-market-based asset portfolio (electricity and gas). Results from adoption of a pentanomial lattice pricing approach show that the set of tolling fees the toller would prefer to pay to the tollee “in equilibrium” is a decreasing function in the portfolio volatility because of the higher risk being borne by the former. Though the toller is willing to fairly pay equal or less than the value created from active management of the power plant, obtaining a positive net profit, the tollee may rely on a constant flow of bullet bond-like installments, securing remuneration of equity capital invested and arrangement of a project financing for plant construction.     

Valuation of Learning Options in Software Development Under Private and Market Risk

Commercial software development is an inherently uncertain activity. Private risk is high, schedule and cost overruns are common, and market success is elusive. Such circumstances call for a disciplined project evaluation approach. This paper addresses the use of market and earned value management data in assessing the economic value of commercial software development projects that are simultaneously subject to schedule, development cost, and market risk. The assessment is based on real options analysis, a financial valuation technique that can tackle dynamic investment decisions under uncertainty. The paper demonstrates the application of real options analysis to a development scenario that consists of two consecutive stages: a mandatory prototyping stage and an optional full-development stage. The full-development stage is undertaken only if the prototype is successful and the market outlook is sufficiently positive at the end of the prototyping stage, thus giving the full-development stage the flavor of an option. The project's staged design increases its value. Real options analyses capture the extra value due to optionality.     

回购合同项目的经济评价与优化

在回购合同模式下,伊朗政府拥有油气的所有权,合同者可以选择现金或购回一定数量的油气作为回收的成本和报酬.回购合同的主要经济参数包括政府优先油比例、项目收益率(ROR)、成本回收期、报酬费回收期、资本成本上限等.合同者的项目收益率是在签订合同时明确规定的,这一指标对产量和投资都非常敏感.政府优先油的比例也是回购合同项目经济评价和业务谈判的重要参数.实现合同者预计的项目收益率的最低油价是拐点油价,项目的拐点油价越高,合同者的经济风险就越大.延长成本回收期和在工程施工可行的情况下尽可能将投资提前是回购合同项目优化的重要途径.合同者要在合理范围内力争获得较大的投资额度,即较大的资本成本上限,同时要在设计上提出较为保守的目标(MDP)产量.     

How do country‐level governance characteristics impact the relationship between R&D and firm value?

This article addresses the question of how country‐level governance characteristics moderate the market valuation of research and development (R&D). Using a valuation model and panel data from companies in the European Union, United States, and Japan, we find that effective corporate governance allows the market to better assess a firm's R&D investments. This finding is the conjunction with the effect of the legal system, the financial system, and mechanisms of control. First, as effectiveness of investor protection increases, the market valuation of R&D projects also increases. Second, more developed financial systems do a better job assessing R&D. Third, effective control mechanisms reinforce the positive effect of R&D on a firm's market value. In sum, our findings shed light on how policymakers can increase the benefits from firms' R&D spending and thus foster economic growth and social welfare using these country‐level governance characteristics.     

企业家人力资本计量模型探讨

本文认为，企业家人力资本是企业价值的关键驱动因素，在对传统的企业家人力资本计量模型进行综评的基础上，提出计量企业家人力资本的期权综合模型方法，印先按照期权模型计量出企业家人力资本的内在价值，再按照模糊计量来衡量企业家人力资本价值发挥的效率，按照综合评价指标体系衡量企业家人力资本的业绩调整系数——“乘数”，借以相对较为完善地衡量企业家人力资本的实际价值。