Real Options Analysis
Assume that you are a manager at a pharmaceutical company where researchers are working on a drug to treat heart disease. The cost of making the drug and the revenues that you will earn from selling an effective drug are uncertain because you do not know how effective the drug will be or what conditions the drug will treat. You need to conduct $1 million of R&D to develop the drug. If you are successful, you will have to undertake clinical trials that could cost either $25 million or $80 million, with a 50 percent chance of each type of trial occurring – one which will generate $40 million revenue, and the other which will generate $60 million in revenue. Your company’s cost of capital is 10 percent. Use the net present and real-options approaches to calculate the discounted cash flows for the project. What does each approach suggest that you do? Why?
