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Handling Complex Decisions in the Development of New Drugs in Pharmaceutical Firms

Handling Complex Decisions in the Development of New Drugs in Pharmaceutical Firms. Cassimon, Engelen and Yordanov. FUR XII , LUISS, Roma , Italy, 22-26 June 2006. Valuation of pharma companies.

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Handling Complex Decisions in the Development of New Drugs in Pharmaceutical Firms

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  1. Handling Complex Decisions in the Development of New Drugs in Pharmaceutical Firms Cassimon, Engelen and Yordanov FUR XII, LUISS, Roma, Italy, 22-26 June 2006

  2. Valuation of pharma companies • Financial analysts typically split the value of a pharmaceutical company in three building blocks: (i) existing marketed products; (ii) new products in the mid to late stage of development (phase II and III of the clinical testing); (iii) early R&D. Valuation is problematic with current models

  3. Real option characteristics of projects • Financial option: right (not an obligation) to buy or sell a certain asset at specific moments at a predetermined price • What are real options? • Recognizing the project itself or certain components as options • A project is an option, whereby the company obtains the right to all future FOCFs the project generates, in exchange for a predetermined price (investment cost of the project) • Different types of real options • Growth options, options to delay, etc.

  4. Real option approach to R&D • Benefits of real option approach compared to traditional models: • Can handle operational flexibility with respect to investment decisions • Abandonnement, delay or adjustment of projects, e.g. stop R&D of particular drug • Takes into account the strategic value of a project because of its interdependence with future projects • R&D give option to follow-up projects • Real option models are better suited to value R&D

  5. I large project FOCF success Follow-up project? Pilot project start t T failure Real option value (ROV) typical: NPV < 0 Typical example of a growth option Project’s value = NPV(pilot) + ROV (follow-up)  if >0, then invest

  6. Extending the growth option Growth option Extension to multiple growth options Sequential option Application to a ‘regulated’ sequential option Sequential drug development option

  7. Discovery (2-10 years) Preclinical Testing Laboratory and animal testing Clinical Phase I 20-80 healthy volunteers used to determine safety and dosage Clinical Phase II 100-300 patient volunteers used to look for efficacy and side effects Clinical Phase III 1000-5000 patient volunteers used to monitor adverse reactions to long-term use FDA Approval Additional Post- Marketing Testing The drug approval process years 3 7 10 14 0

  8. Opening the R&D black box

  9. fundamental research Development of a new drug commercialisation approval by government NPV1 success clinical test phase 3 clinical test phase 2 success failure NPV2 success clinical test phase 1 failure pre-clinical test phase success failure success failure success failure failure

  10. R&D on new drug as a chain of options (a)first option– decision to start preclinical phase; (b)second option– decision to start first clinical trial phase; (c)third option –decision to start second clinical trial phase; (d)fourth option– decision to start third clinical trial phase; (e) fifth option–decision to file for regulatory approval; (f) sixth option – decision to launch the new drug on the market.

  11. How to value this chain of real options? • Chain of real options in drug development can be seen as a case of compound option models • Geske (1979) – 2-fold compound option (option on an option) • R&D of new drug – 6-fold compound option • We use the extended n-fold compound option model of Cassimon et al. (2004) • Programmed in Matlab

  12. Case-study Xandee Biochemical, Ltd.

  13. INS-84 JR-32 FR-242 DIVE-4 MF-164 interim products Its research and product portfolio commerciali- zation preclinical clinical I clinical II clinical III FDA approval • MV of product portfolio is the sum of: • assets in place (interim products) • unexercised compound growth options (pipeline)

  14. Valuation of R&D and product portfolio

  15. Option ti Ki V n-fold COV Panel A – Product JR-32 ( = 0.81; wacc = 23%) – Preclinical phase 1 1.5 8.3 2 2.5 29.1 3 4 55.7 4 6.5 14.1 5 8 50.6 81.7 30.4 Panel B – Product INS-84 ( = 0.64; wacc = 18%) – Preclinical phase 1 3 15.8 2 4 48.5 3 6 96.4 4 8.5 25.3 5 10.5 107.2 72.7 15.6 Details of its drug development pipeline Legend: ti is the maturity date for the compound call option Ci (expressed in years), Ki is the exercise price for the compound call option Ci,; V is the current value of the underlying project;  is the instantaneous standard deviation of the project return; wacc is the risk-adjusted discount rate of the project and COV is the compound option value based on the corresponding n-fold compound option model. Ki,, V, I and COV in million USD.

  16. Panel C – Product FR-242 ( = 0.78; wacc = 21%) – Clinical I phase 1 0.5 10.2 2 2 33.7 3 5 8.3 4 6.75 60.0 65.8 19.4 Panel D – Product DIVE-4 ( =0.63; wacc = 18%) – Clinical III phase 1 2 8.5 2 3.5 29.4 61.1 33.4 Panel E – Product MF-164 ( = 0.46; wacc = 15%) – Approval phase 1 1 25.2 43.8 16.2 Details of its drug development pipeline Legend: ti is the maturity date for the compound call option Ci (expressed in years), Ki is the exercise price for the compound call option Ci,; V is the current value of the underlying project;  is the instantaneous standard deviation of the project return; wacc is the risk-adjusted discount rate of the project and COV is the compound option value based on the corresponding n-fold compound option model. Ki,, V, I and COV in million USD.

  17. Decomposition of its market value • 39% of its MV comes from early stage R&D • 86% of its MV comes from drug development pipeline • Only 14% of its MV comes from existing products

  18. Conclusions • Product portfolio of a pharmaceutical firm consists of exercised (assets in place) and unexercised (growth opportunity) real options • Real option component can be valued using generalised n-fold compound option models • Benefits: • possible to decompose MV of product portfolio in different components linked to specific phases of drug development process • Better insight in different value blocks of pharmaceutical firm (over the full range of phases of drug development)

  19. If you have … comments or suggestions, proposals for research collaboration, or proposals for consulting work, … please contact us at: p.engelen@econ.uu.nl Peter-Jan Engelen Utrecht University, Vredenburg 138 3511BG Utrecht, Netherlands Contact information

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