Valuing multistage investment projects in the pharmaceutical industry

Multistage investment projects are subject to several sources of uncertainty, but also present significant embedded flexibilities both during and after the development process. An important characteristic of this class of projects is that as the firm incurs a cost and invests, it learns both about the difficulty of developing and implementing the project and also about market conditions. We develop a real options model where the firm continuously updates its prospects of timely completion and future market conditions. This information can then be used to optimally decide whether further investment is warranted or not, given the expected future revenues of the whole venture. We apply this model to a Research and Development (R&D) project in the pharmaceutical industry and value this investment opportunity as a compound contingent claim where the underlying asset is the value of the completed project, and find that the opportunities to abandon and to expand into related markets and applications once the original product is proven successful have a significant impact on the value of the project as a whole. This article differs from previous work in the field by capturing the potential upsides that may occur during product development through a novel quality model, and their effect on the expansion opportunities during the market phase. We use a simulation approach for the solution and show that for complex real options models, this method can be an effective way to value such projects while providing adequate precision compared to other models in the literature.