REAL OPTIONS AND THE EVALUATION OF RESEARCH AND DEVELOPEMENT PROJECTS IN THE PHARMACEUTICAL INDUSTRY : A CASE STUDY(Special Issue on Theory, Methodology and Applications in Financial Engneering)

Trang, Nguyễn Thu; Takezawa, Naoya; Takezawa, Nobuya

doi:10.15807/jorsj.45.385

Cited by 5 publications

(1 citation statement)

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“…In particular, they consider the case of Nihon Schering, which once their drug Y (the name used for convenience) gets the approval from the government, is allowed to undertake further research at a future time for developing other drugs similar to Y. Trang et al (2002) assume that the total cash inflow resulting from the growth opportunity is equal to a certain fraction of the total cash inflow due to drug Y, while the cost of the investment to be made at the time is equal to . The volatility of the project is assumed to be equal to 35%.…”

Section: Real Option Pricing Under Stochastic Interest Ratesmentioning

confidence: 99%

Valuing strategic investments under stochastic interest rates: A real option approach

Ballestra¹,

Pacelli²,

Radi³

2019

COC

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One of the most challenging issues in management is the valuation of strategic investments. In particular, when undertaking projects such as an expansion or the launch of a new brand, or an investment in R&D and intellectual capital, which are characterized by a long-term horizon, a firm has also to face the risk due to the interest rate. In this work, we propose to value investments subject to interest rate risk using a real options approach (Schulmerich, 2010). This task requires the typical technicalities of option pricing, which often rely on complex and time-consuming techniques to value investment projects. For instance, Schulmerich (2010) is, to the best of our knowledge, the first work where the interest rate risk is considered for real option analysis. Nevertheless, the valuation of investment projects is done by employing binomial trees, which are computationally very expensive. In the current paper, a different modeling framework (in continuous-time) for real option pricing is proposed which allows one to account for interest rate risk and, at the same time, to reduce computational complexity. In particular, the net present value of the cash inflows is specified by a geometric Brownian motion and the interest rate is modeled by using a process of Vasicek type, which is calibrated to real market data. Such an approach yields an explicit formula for valuing various kinds of investment strategies, such as the option to defer and the option to expand. Therefore, the one proposed is the first model in the field of real options that accounts for the interest rate risk and, at the same time, offers an easy to implement formula which makes the model itself very suitable for practitioners. An empirical analysis is presented which illustrates the proposed approach from the practical point-of-view and highlights the impact of stochastic interest rates in investment valuation.

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Section: Real Option Pricing Under Stochastic Interest Ratesmentioning

confidence: 99%