[MUSIC] Our topic now is real options. Okay? We're still talking about investments, so real options is still going to be about how to make right investment decisions. So in a sense is a follow up of the discussion we just had about net present value and IIR, okay? The difference is that we are going to incorporate options into our calculations, okay? So far what we've done, essentially, is we've been assuming that the decision is all or nothing. You either take a project or you don't. You either replace a machine or you don't. Okay? But in real life, investment projects are going to come attached with what we call a real option. Okay? So this could be an option to cancel the project, to abandon it. It could be an option to modify. And the very important option that's actually going to be our starting point, is that some investments actually create future opportunities. Okay. Rather than creating current cash flow, they create future opportunities to invest. So specifically, we're thinking about research and development, R&D. So let's start with that, actually. It's one of the most important applications of real option analysis. How to value R&D, how to make a decision about R&D expenses, okay? If you think about R&D, the very purpose of R&D is to create an option to invest in the future. When a company is spending dollars to do research to develop new drugs, for example, the goal of the company is to discover something that can become a product. Right? So the value of R&D is going to come from this creation process. Okay. Rather than creating future cash flows, you're creating an option to invest, right. So, let's work with a specific example, and try to put some numbers and try to think about how we would value R&D. Right? So suppose a drug company has estimated the cost of researching a new drug that you're trying to develop and this drug is going to cost $30,000,000. Okay? It's a new diabetes drug just to be concrete. Okay? Question is, how do we compute the NPV of the R&D investment? Right? Every time a company spends money, and $30,000,000 is nothing in this, right? Every time a company spends money, we have to think about shareholder value. Right? So are these investments in R&D indeed going to increase shareholder value? Right? And we cannot just guess. We have to go on to go ahead, try to do the calculations to come up with this NPV. Okay? So how would we model this? The first thing to notice is that the R&D is not necessarily going to generate a useful drug. Okay? So the R&D may generate, it's research right? It's research like what I do for a living as well. Sometimes our projects work, and sometimes our projects don't work and we end up with nothing. So the first thing we have to think about is the R&D only produces a useful drug with a certain probability. The way we're gonna think about this is by using a decision tree. So what you have here in the slide is a decision tree, we're modelling the investment. So today you decide if you take this investment, if you spend $30,000,000 in research. There is a chance that you're going to develop a new drug, but there is also a chance that there's gonna be failure, your research is going to produce nothing, and no drug is going to be developed. Okay. So the first thing that the drug company has to estimate is this probability. What is the probability that we are going to end up in the right side of the tree here? Right? We want to be on the right side of the success side. How can we do that? This is obviously going to be hard. It's especially hard for novel projects, think about this. Research is going on. It's probably something new. Something that is going to create value. Something novel. Okay? So it's not easy to estimate this probability. Okay? But it doesn't mean that we shouldn't do it. We have to do it if we're going to figure out the NPV of the R&D investment, we are gonna have to do this somehow. Right? The way that drug companies do it is by using experience. They've done related research in all the drugs or educated guesswork. Here is some data that is useful. There are typically four phases to prove the safety and the efficacy of a new drug. You start small, testing a few healthy volunteers, okay. And then do you know, some drugs already fail at this stage. Right. 70% manage to go to phase two. Then on phase two, you increase the number of volunteers. Right. Again, a certain percentage goes to phase three. Right. Phase three then is going to take a number of years. Right? That's when you really start spending the dollars to research this new drug. You go global, increase the test to thousands of patients, and then at phase 4 you have to get approval from a regulator. Here in the U.S., the regulator is the FDA. The Food and Drug Administration that is responsible to approve whether a new drug should be used in real life patients or not. So, just by looking at these numbers you see that the probability is small, right? Only 70% go through phase one, 33% go through phase 2, then there are two more phases, all right? So the probability is quite small. For any individual drug, it's going to be on the, less than 10%. Here let's say that our probability's 5%. So there is a 5%, the drug company estimates a 5% probability that this new drug is going to produce, that this research is going to produce a successful drug. And then there is a 95% probability that the drug will not be developed. There's gonna be failure. Okay? It's small probability. That doesn't mean that the R&D shouldn't be done. We have to do more calculations. Okay, the first thing we need to figure out is, how much is the company going to have to spend if the R&D is successful? Right, remember what we talked about in the beginning, the R&D is not generating cash flows immediately, the R&D is actually generating an option to invest. If you're R&D, what you're creating is the rights to spend money, if you want. So just gonna spend more money to begin with. Okay? Recently I read a very interesting interview with the Chief Financial Officer of a drug company here in the U.S. called Parexel International and the CFO is precisely describing this process. And one of the points that he made is that each phase requires an increasing investment. And that once you get to the late phases, once the drug gets close to being a success, the investments become very large. Okay? So it could cost $500,000,000 for a single drug to be developed. So let's say for our example that the required investment is $1 billion. So here we have the 5% chance that you're going to spend $1,000,000,000. So far this is not looking very good right? All we've done is estimating the chance that we're going to spend more money right? Of course, what we need to get at now is to figure out the cash flows that this investment is going to produce. So if the drug is successful, you spend $1,000,000,000 and then you're gonna generate profit. It turns out that the regulators, I understand that developing a drug is very costly process. It takes many years of research, it takes this large investments. So in many countries in the world we have this concept of a patent. So the FDA will typically grant a patent for a certain number of years, so our example here let's say it's 10 years, okay? The patent creates the monopoly for the company during that period. So the company will probably have higher profits because it's the only one that can produce exactly that drug. After that, competitors are going to be able to copy this drug, okay? So how would we model that? There's going to be a two stage cash flow process, right? Initially, the drug is going to generate high profits. Lets say here it's $200,000,000 a year, okay for these ten years. Then the cash flow is going to drop to $20,000,000 a year in perpetuity. Again, the right horizon to consider is typically an infinite horizon, as we discussed already in this module. Suppose then also that the discount rate is 6%. What we need to do now is to figure out the present value of these cash flows. Okay, at the point that the drug is developed, what is the present value of this cash flows? Okay and yes, this is one more present value example, right. Practicing is always great. Practicing is what makes perfect, both for guitar playing and for finance. Okay, so let's go on and do that, okay. So here what you have are the cash flow of the time line, right. So 1, 2, 3, 4 right. $200,000,000 cash flow for the first 10 years and then the cash flow drops to $20,000,000, right. I have the calculation here for you. Notice one thing, right. Because we have the infinite horizon at the end, we're going to have to use the perpetuity formula. Right. We have this $20,000,000 cash flow that keeps going on forever. The discount rate is 6%, so we know we're going to have to use the perpetuity formula to divide 20 by 6% to get the value of that perpetuity at the end. And then notice that if you apply the present value formula, the first cash flow is happening in year 11. This value is going to go here in year 10. Okay? The value of this perpetuity is going to accrue to the firm 10 years from now, when the patent expires. It's as if the company were like selling the drug at that time and the value of the drug is plainly divided by 6%. So you have that here, 10 years from now in addition to the cash flow of $200,000,000 that the company's still producing in that time. Okay, and then you have the other cash flows that we are discounting back. Again at this point you can do Excel. You can use Excel, right. You're gonna have to apply the perpetuity formula at the end, but after you have figured out the perpetuity, you can definitely use Excel the calculate the present value of the cash flows. Which here we got to be $1.658 billion. Okay? You are investing $1,000,000,000. So what this means is if the R&D is successful, if the drug is developed, we are forecasting, we are estimating, we are guessing. Right? We are not sure but we are guessing there's gonna be an NPV of $658,000,000. Okay? So we can go back here and add that to our decision tree. So now we have all the numbers. If you invest $30,000,000 you have a 5% chance of generating a net present value of $658,000,000. And then there is a 95% chance that you get nothing, right? We still have to think about one more issue before we do the final evaluation, which is, how long does it take? Research takes time. Like I said, this is one of the things I do for a living is do research, write papers. I can tell you that each paper that I work on can take two, three, even four or five years, to between the time you start and the time you complete. Research should develop a drug is similar, there's lots of people working, but it usually take a few years to decide if the drug is going to be successful or not. So for our example here, let's say it's three years. What I'm saying is that lets say the length of this period between the $30,000,000 investment and the development of the drug is three years. Okay? And now the question for you try to with this data, we've figure everything out except the NPV of the R&D try to do the calculation yourself. And here it is for you, okay. So that's how you would do it. You have the minus 30 in the beginning of course. Right? And notice that since there is only a 5% chance that you get a positive NPV, we have to multiply the 658 million by 5%. Right? There's only a 5% chance you get that, and then we have to do it through discount by three periods. Which is was by our assumption it's gonna take three years. Okay. If those numbers are correct, we are getting an NPV of minus $2.37 million. Okay. So we got the negative NPV for the R&D investment. Right? What this means is that despite the large potential benefit of the drug, right? You could generate really a ton of money, but the R&D's just not making sense for shareholders, okay? The risk of failure is too high. It takes too long to generate profits, okay? At this point what the company could do is to try to change the parameter somehow, right? In a real way, not playing with parameters, not making optimistic assumptions. But what I would recommend is that the company should try to lower the cost of research. Is there a way of doing this research In a way that's maybe going to cost less than $30,000,000. Is that a way of getting results sooner? Any of these changes might cause the drug to become positive NPV and will definitely help the company.
