0:15

Our topic now is real options.

Â Okay?

Â We're still talking about investments, so

Â real options is still going to be about how to make right investment decisions.

Â So in a sense is a follow up

Â of the discussion we just had about net present value and IIR, okay?

Â The difference is that we are going to incorporate options into our

Â calculations, okay?

Â So far what we've done, essentially,

Â is we've been assuming that the decision is all or nothing.

Â You either take a project or you don't.

Â You either replace a machine or you don't.

Â Okay?

Â But in real life,

Â investment projects are going to come attached with what we call a real option.

Â Okay?

Â So this could be an option to cancel the project, to abandon it.

Â It could be an option to modify.

Â And the very important option that's actually going to be our starting point,

Â is that some investments actually create future opportunities.

Â Okay.

Â Rather than creating current cash flow,

Â they create future opportunities to invest.

Â So specifically, we're thinking about research and development, R&D.

Â 1:22

So let's start with that, actually.

Â It's one of the most important applications of real option analysis.

Â How to value R&D, how to make a decision about R&D expenses, okay?

Â If you think about R&D,

Â the very purpose of R&D is to create an option to invest in the future.

Â When a company is spending dollars to do research to develop new drugs,

Â for example, the goal of the company is to

Â discover something that can become a product.

Â Right?

Â So the value of R&D is going to come from this creation process.

Â Okay.

Â Rather than creating future cash flows,

Â you're creating an option to invest, right.

Â So, let's work with a specific example,

Â 2:16

and try to put some numbers and try to think about how we would value R&D.

Â Right?

Â So suppose a drug company has estimated the cost of researching a new drug

Â that you're trying to develop and this drug is going to cost $30,000,000.

Â Okay? It's a new diabetes drug just to

Â be concrete.

Â Okay?

Â Question is, how do we compute the NPV of the R&D investment?

Â Right? Every time a company spends money,

Â and $30,000,000 is nothing in this, right?

Â Every time a company spends money, we have to think about shareholder value.

Â Right?

Â So are these investments in R&D indeed going to increase shareholder value?

Â Right? And we cannot just guess.

Â We have to go on to go ahead, try to do the calculations to come up with this NPV.

Â Okay?

Â So how would we model this?

Â The first thing to notice is that the R&D is not necessarily going to generate

Â a useful drug.

Â Okay?

Â So the R&D may generate, it's research right?

Â It's research like what I do for a living as well.

Â Sometimes our projects work, and sometimes our projects don't work and

Â we end up with nothing.

Â So the first thing we have to think about is the R&D

Â only produces a useful drug with a certain probability.

Â The way we're gonna think about this is by using a decision tree.

Â So what you have here in the slide is a decision tree,

Â we're modelling the investment.

Â So today you decide if you take this investment,

Â if you spend $30,000,000 in research.

Â There is a chance that you're going to develop a new drug, but

Â there is also a chance that there's gonna be failure,

Â your research is going to produce nothing, and no drug is going to be developed.

Â Okay.

Â So the first thing that the drug company has to estimate is this probability.

Â What is the probability that we are going to end up

Â in the right side of the tree here?

Â Right?

Â We want to be on the right side of the success side.

Â How can we do that?

Â This is obviously going to be hard.

Â It's especially hard for novel projects, think about this.

Â Research is going on.

Â It's probably something new.

Â Something that is going to create value.

Â Something novel.

Â Okay?

Â So it's not easy to estimate this probability.

Â Okay?

Â But it doesn't mean that we shouldn't do it.

Â We have to do it if we're going to figure out the NPV of the R&D investment,

Â we are gonna have to do this somehow.

Â Right?

Â The way that drug companies do it is by using experience.

Â They've done related research in all the drugs or educated guesswork.

Â Here is some data that is useful.

Â There are typically four phases to prove the safety and the efficacy of a new drug.

Â You start small, testing a few healthy volunteers, okay.

Â And then do you know, some drugs already fail at this stage.

Â Right.

Â 70% manage to go to phase two.

Â Then on phase two, you increase the number of volunteers.

Â Right.

Â Again, a certain percentage goes to phase three.

Â 6:12

So, just by looking at these numbers you see that the probability is small, right?

Â Only 70% go through phase one, 33% go through phase 2,

Â then there are two more phases, all right?

Â So the probability is quite small.

Â For any individual drug, it's going to be on the, less than 10%.

Â Here let's say that our probability's 5%.

Â So there is a 5%, the drug company estimates

Â a 5% probability that this new drug is going to produce,

Â that this research is going to produce a successful drug.

Â And then there is a 95% probability that the drug will not be developed.

Â There's gonna be failure.

Â Okay?

Â It's small probability.

Â That doesn't mean that the R&D shouldn't be done.

Â We have to do more calculations.

Â Okay, the first thing we need to figure out is,

Â how much is the company going to have to spend if the R&D is successful?

Â Right, remember what we talked about in the beginning, the R&D is not generating

Â cash flows immediately, the R&D is actually generating an option to invest.

Â If you're R&D, what you're creating is the rights to spend money, if you want.

Â So just gonna spend more money to begin with.

Â Okay? Recently I read a very interesting

Â interview with the Chief Financial Officer of a drug company here in the U.S.

Â called Parexel International and the CFO is precisely describing this process.

Â 8:07

So here we have the 5% chance that you're going to spend $1,000,000,000.

Â So far this is not looking very good right?

Â All we've done is estimating the chance that we're going to

Â spend more money right?

Â Of course, what we need to get at now is to figure out the cash

Â flows that this investment is going to produce.

Â So if the drug is successful, you spend $1,000,000,000 and

Â then you're gonna generate profit.

Â It turns out that the regulators,

Â I understand that developing a drug is very costly process.

Â It takes many years of research, it takes this large investments.

Â So in many countries in the world we have this concept of a patent.

Â So the FDA will typically grant a patent for a certain number of years,

Â so our example here let's say it's 10 years, okay?

Â The patent creates the monopoly for the company during that period.

Â So the company will probably have higher profits because it's the only one

Â that can produce exactly that drug.

Â After that, competitors are going to be able to copy this drug, okay?

Â So how would we model that?

Â There's going to be a two stage cash flow process, right?

Â Initially, the drug is going to generate high profits.

Â Lets say here it's $200,000,000 a year, okay for these ten years.

Â Then the cash flow is going to drop to $20,000,000 a year in perpetuity.

Â Again, the right horizon to consider is typically an infinite horizon,

Â as we discussed already in this module.

Â Suppose then also that the discount rate is 6%.

Â What we need to do now is to figure out the present value of these cash flows.

Â Okay, at the point that the drug is developed,

Â what is the present value of this cash flows?

Â Okay and yes, this is one more present value example, right.

Â Practicing is always great.

Â Practicing is what makes perfect, both for guitar playing and for finance.

Â Okay, so let's go on and do that, okay.

Â So here what you have are the cash flow of the time line, right.

Â So 1, 2, 3, 4 right.

Â $200,000,000 cash flow for the first 10 years and

Â then the cash flow drops to $20,000,000, right.

Â I have the calculation here for you.

Â Notice one thing, right.

Â Because we have the infinite horizon at the end,

Â we're going to have to use the perpetuity formula.

Â Right.

Â We have this $20,000,000 cash flow that keeps going on forever.

Â The discount rate is 6%, so we know we're going to

Â have to use the perpetuity formula to divide 20

Â by 6% to get the value of that perpetuity at the end.

Â And then notice that if you apply the present value formula,

Â the first cash flow is happening in year 11.

Â This value is going to go here in year 10.

Â Okay?

Â The value of this perpetuity is going to accrue to the firm 10 years from now,

Â when the patent expires.

Â 11:21

It's as if the company were like selling the drug at that time and

Â the value of the drug is plainly divided by 6%.

Â So you have that here, 10 years from now in addition to

Â the cash flow of $200,000,000 that the company's still producing in that time.

Â Okay, and then you have the other cash flows that we are discounting back.

Â Again at this point you can do Excel.

Â You can use Excel, right.

Â You're gonna have to apply the perpetuity formula at the end,

Â but after you have figured out the perpetuity,

Â you can definitely use Excel the calculate the present value of the cash flows.

Â Which here we got to be $1.658 billion.

Â Okay?

Â You are investing $1,000,000,000.

Â So what this means is if the R&D is successful, if the drug is developed,

Â we are forecasting, we are estimating, we are guessing.

Â Right? We are not sure but

Â we are guessing there's gonna be an NPV of $658,000,000.

Â 12:47

We still have to think about one more issue before we do the final evaluation,

Â which is, how long does it take?

Â Research takes time.

Â Like I said,

Â this is one of the things I do for a living is do research, write papers.

Â I can tell you that each paper that I work on can take two, three,

Â even four or five years, to between the time you start and the time you complete.

Â Research should develop a drug is similar, there's lots of people working, but

Â it usually take a few years to decide if the drug is going to be successful or not.

Â So for our example here, let's say it's three years.

Â What I'm saying is that lets say the length of this period between

Â the $30,000,000 investment and the development of the drug is three years.

Â Okay?

Â 13:49

And here it is for you, okay.

Â So that's how you would do it.

Â You have the minus 30 in the beginning of course.

Â Right?

Â And notice that since there is only a 5% chance that you get a positive NPV,

Â we have to multiply the 658 million by 5%.

Â Right?

Â There's only a 5% chance you get that, and

Â then we have to do it through discount by three periods.

Â Which is was by our assumption it's gonna take three years.

Â Okay.

Â If those numbers are correct, we are getting an NPV of minus $2.37 million.

Â Okay.

Â So we got the negative NPV for the R&D investment.

Â Right? What this means is that despite the large

Â potential benefit of the drug, right?

Â You could generate really a ton of money,

Â but the R&D's just not making sense for shareholders, okay?

Â The risk of failure is too high.

Â It takes too long to generate profits, okay?

Â At this point what the company could do

Â is to try to change the parameter somehow, right?

Â In a real way,

Â not playing with parameters, not making optimistic assumptions.

Â But what I would recommend is that the company should try

Â to lower the cost of research.

Â Is there a way of doing this research

Â In a way that's maybe going to cost less than $30,000,000.

Â