Risk Management & Real Options IX. The Value of Phasing Stefan Scholtes Judge Institute of Management University of Cambridge MPhil Course 2004-05

Risk Management & Real Options

IX. The Value of Phasing

Stefan ScholtesJudge Institute of Management

University of Cambridge

MPhil Course 2004-05

2 September 2004 © Scholtes 2004 Page 2

Course content

I. IntroductionII. The forecast is always wrong

I. The industry valuation standard: Net Present Value

II. Sensitivity analysisIII. The system value is a shape

I. Value profiles and value-at-risk charts

II. SKILL: Using a shape calculatorIII. CASE: Overbooking at EasyBeds

IV. Developing valuation modelsI. Easybeds revisited

V. Designing a system means sculpting its value shapeI. CASE: Designing a Parking Garage

III. The flaw of averages: Effects of

system constraintsVI. Coping with uncertainty I:

DiversificationI. The central limit theoremII. The effect of statistical

dependenceIII. Optimising a portfolio

VII. Coping with uncertainty II: The value of information

I. SKILL: Decision Tree Analysis

II. CASE: Market Research at E-Phone

VIII. Coping with uncertainty III: The value of flexibility

I. Investors vs. CEOs

II. CASE: Designing a Parking Garage II

III. The value of phasing

IV. SKILL: Lattice valuation

V. Case: Valuing a drug development projects


Key messages

Traditional valuation techniques have severe limitations when applied to the valuation of multi-stage projects

• Need to take downstream flexibility into account• Will present scenario tree approach as an alternative to Monte Carlo

simulation

Effect is magnified in contract valuation• Need to take account of your own as well as your contract partner’s

flexibility• Need to understand incentives provided by contract terms• Will present how scenario tree approach can be used

Will illustrate these points, using project valuation in the pharmaceutical industry as an example


Pharmaceutical R&D

0

5

10

15

20

25

30

35

0

20

40

60

80

100

120

140

160

180

200No. of new drugs R&D expense in $billion

Source: Tufts Centre for the study of drug development


Challenges for Big Pharma

R&D is high risk• 1:10,000 synthesized components make it to the market• Long and increasing time to market (12-15 years) • Many marketed drugs do not return development costs

Pharma relies on blockbuster drugs (sales > $ 1,000 M)• Increasingly difficult to discover• 80% of current blockbuster patents will expire by 2007

Emerging new technologies• Move from chemistry to biology/genetics biotech industry• Hope for new blockbuster potentials

Strategic interests in co-development with smaller biotech companies

• Early access to drugs with blockbuster potential• Access to and learning about new technologies


Challenges for Biotech

Cash refuelling is difficult in today’s market• Necessary to drive drugs through development process• Very few biotechs have drugs in the market

Biotech focus on upstream activity, based on protected technology platform

• Is this a sustainable business model?

Strategic aim of many biotechs: Move downstream• Move from a mere technology provider to a fully integrated

biopharmaceutical company (FIBCO) with products in the market

Strategic interests in partnership with big pharma companies• Access to capital to finance projects further downstream• Learning about downstream business, in particular building

competence in marketing and sales• Development of a suitable sales force to enable effective

participation in the market (e.g. selling non-blockbuster drugs effectively)


Industry with similar risk issues: Oil & Gas

High risk

Long time-lines to revenues

Exploit portfolio effect to cope with risk• Identify promising new therapeutic areas / plays

Reliance on big discoveries• Blockbusters / Elephants

High but staged investments

Reliance on new technologies


Agenda

Explain how a drug is typically valued• Applies generically to staged projects

Explain how contracts are valued in practice

Illustrate limitations of traditional valuation with regard to • Risk sharing• Downstream control

Suggest alternative valuation technique


What’s the value of a staged investment?

Phase 1 Phase 2 SalesPhase 3

-$10 M -$80 M -$120 M -$500 M

$0 $0 $0 $1,000 M

Now Year 7Year 4 Year 9

80% 50%70%Success?

Time




-$10 M -$80 M -$120 M -$500 M

$0 $0 $0 $1,000 M


80% 50%70%Success?

Time

Traditional valuation - risk-adjusted NPV (R-NPV or ENPV)

Sum of discounted cash flows weighted with probability of occurrence




-$10 M -$80 M -$120 M -$500 M

$0 $0 $0 $1,000 M

Traditional valuation - risk-adjusted NPV (R-NPV or ENPV)

Sum of discounted cash flows weighted with probability of occurrence


80% 50%70%Success?

Time

-$10 -80% * $80 -80%*70% * $120 +80%*70%*50% * $(1000-500) = -$1.2




-$10 M -$80 M -$120 M -$500 M

$0 $0 $0 $1,000 M

What if sales / cost projections changeduring development?


80% 50%70%Success?

Time




-$10 M -$80 M -$120 M -$500 M

$0 $0 $0 Projected Sales


80% 50%70%Success?

Time

$1,400

$1,600

$400

$800

$1,200$1,00

0

$600$800

$1,200$1,00

0

50/50 chance ofup or down




-$10 M -$80 M -$120 M -$500 M

$0 $0 $0


80% 50%70%Success?

Time

$1,400

$1,600

$400

$800

$1,200$1,00

0

$600$800

$1,200$1,00

0


Projected Sales

1/8

3/8

3/8

1/8

Average= $1,000



$1,400

$1,600

$400

$800

$1,200$1,00

0

$600$800

$1,200$1,00

0



80% 50%70%Success?

Time

-$10 M -$80 M -$120 M -$500 M

How does the project value change with changing sales projections?

Want to take account of future continuation decisions



-$10 M -$80 M -$120 M -$500 M

$1,400

50/50 chance of up or down

$1,600

$400

$800

$1,200$1,00

0

$600$800

$1,200$1,00

0

$?

$?

$?

$?


80% 50%70%Success?

Time

Key idea: Begin in the future and evaluate backwards



-$10 M -$80 M -$120 M -$500 M

$1,400


$1,600

$400

$800

$1,200$1,00

0

$600$800

$1,200$1,00

0

$1,100$700

$300

$0


80% 50%70%Success?

Time

100,1500600,1 :NPV

700500200,1 :NPV

300500800 :NPV

launcht Don' 100500400 :NPV



-$10 M -$80 M -$120 M -$500 M

$1,400


$1,600

$400

$800

$1,200$1,00

0

$600$800

$1,200$1,00

0

$1,100$700

$300

$0$?

$?

$?


80% 50%70%Success?

Time



$1,200

-$10 M -$80 M -$120 M -$500 M

$1,400


$1,600

$400

$800

$1,200$1,00

0

$600$800

$1,000

$1,100$700

$300

$0$0

$130

$330


80% 50%70%Success?

Time

330120-700)50%1,100(50%50% :NPV-R

130120-300)50%700(50%50% :NPV-R

proceedt Don'45120-300)(50%50% :NPV-R




-$10 M -$80 M -$120 M -$500 M

$1,400

$1,600

$400

$800

$1,200$1,00

0

$600$800

$1,200$1,00

0

$1,100$700

$300

$0$0

$130

$330

$0

$81


80% 50%70%Success?

Time



$1,200

-$10 M -$80 M -$120 M -$500 M

$1,400


$1,600

$400

$800

$1,200$1,00

0

$600$800

$1,000

$1,100$700

$300

$0$0

$130

$330

$0

$81$22.4


80% 50%70%Success?

Time



$1,200

-$10 M -$80 M -$120 M -$500 M

$1,400


$1,600

$400

$800

$1,200$1,00

0

$600$800

$1,000

$1,100$700

$300

$0$0

$130

$330

$0

$81$22.4


80% 50%70%Success?

Time

Read off optimal future decisions:Abandon after phase 1 if the downside scenario occurs, else continue whenevera phase is successful



0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

-400 -300 -200 -100 0 100 200 300 400 500 600 700 800 900 1000

Target Value ($M)

Pro

bab

ilit

y th

at t

arg

et v

alu

e is

no

t ac

hie

ved

With Decisions Without Decisions

Let’s not forget: The value of a project is a shape!

Project abandonmentwas right in hindsight

Project abandonment was wrong in hindsight


Spreadsheet analysis

Model of phase-to-phase change of revenue estimatesHere: 50/50 chance of 200 up or 200 down (you may want to use a different type of model, e.g. percentage deviations,three or more change scenarios, etc.)


Walk away if NPV is negative.

In this case value = 0


=MAX(E2-$E$8,0)

NPV for high revenue scenario= PV of sales - investment





R-NPV=Expected PV of future sales - investment

Success probability of phase III

Expectedrevenue if phaseIII is successful

Cost to proceed to phase III

=MAX($D$7*(50%*E10+50%*E11)-$D$8,0)




Calculate R-NPV backwards as for Phase III



Value of the project with downstream decisions taken into account




Value as a function of uncertainty

-5

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35

0 50 100 150 200 250

Phase-to-phase scenario deviations from projected sales

Val

ue

($

Mio

)

Value with downstream decisions Value w/o downstream decisions

R-NPV is correct if uncertainty is low or if there are no downstream decisionsOption value comes from interplay between uncertainty and flexibility

R-NPV=-$1.2M



Value as a function of uncertainty

-5

0

5

10

15

20

25

30

35

0 50 100 150 200 250

Phase-to-phase scenario deviations from projected sales

Val

ue

($

Mio

)

Value with downstream decisions Value w/o downstream decisions

R-NPV is correct if uncertainty is low or if there are no downstream decisionsOption value comes from interplay between uncertainty and flexibility

R-NPV=-$1.2M

Key for communication: Clear connection between DCF value and Real Options value


A quick word about discount rates

Recall

Discount rate reflects• Reward for taking general macro-economic risk (government bond

rate)• Reward for taking debt risk: Default (corporate spread = corporate

bond rate – government bond rate)• Reward for taking equity risk: Volatile returns (CAPM)

Practice: Company hurdle rate, reflecting WACC• Generally higher than government bond rates (“risk-free” rate,

time-value of money)• Reflecting intrinsic risk of company / industry


Discount rates

Distinguish between “Options phase” and “Asset phase” of a project

• Investments during options phase are considered as payment for “option to make a (typically larger) future investment”

• Asset phase begins when the final “big investment” is madeU̵ Launch of new productU̵ IPO for VC

Options phase is riskier, capital is more expensive• Apply higher discount rate during options phase and lower rate

during asset phase


Discounting in staged projects

NPV-type analysis: Time for calculation of project value is time of investment

• Discounting to today

Real Options: Time of calculation of project value should be the time when the investment turns into a standard asset (i.e. no more investment in option)

Discount forward to beginning of asset phase using high rate during “Options” phase

Discount backwards to beginning of asset phase using standard discount rate


Year 0 3 5 8 9 10 11Success Probability 20% 40% 70% 100%Capital cost 30% 30% 30% 10% 10% 10% 10%Cash flow -1 -5 -20 -320 225 270 90Options discounting:Year -8 -5 -3 0 1 2 3DCF -8.15731 -18.5647 -43.94 -320 204.5455 223.1405 67.61833Expected DCF -8.15731 -3.71293 -3.5152 -17.92 11.45455 12.49587 3.786627Value in year 0: -5.5684NPV discounting:Year 0 3 5 8 9 10 11DCF -1 -2.27583 -5.38658 -149.282 95.42196 104.0967 31.54445Expected DCF -1 -0.45517 -0.43093 -8.35981 5.34363 5.829415 1.766489Value in year 0: 2.693629

Options Phase Asset Phase

Example




-$10 M -$80 M -$120 M -$500 M

$0 $0 $0 $1,000 M


80% 50%70%Success?

Time

Discounted forward to year 9at “options discount rate”

Discounted backwards to year 9 at WACC


Summary of scenario tree approach

What triggers downstream decisions?• “underlying uncertainty”• Here: Revenue estimate

Model evolution of the underlying uncertainty• Scenario tree

Model evolution of the FUTURE project value for all scenarios, taking account of future decisions

• Begin in the future and evaluate backwards in time• Surprisingly simple in spreadsheets


Summary of key concepts

A staged project cannot be properly evaluated without taking downstream decisions into account

• Another manifestation of the FLAW OF AVERAGES• Value of the project on the basis of average sales = -$1.2 M• Average value of the project = $22.4 M

Downstream decisions increase project value• Flexibility: Flaw works for you• Constraints: Flaw works against you (e.g. capacity case)


A bit more about the mechanics…


Modelling the underlying

Underlying is often an “expected value” in the sense that it is our best estimate (or the market price) associated with an uncertain future value

• Model: stock price• Example: Revenue expectations for drug

Simple models: • Binomial lattice • Trinomial lattice

Possible models, given value S today, • Additive: Upward Scenario = S+U, Downward Scenario = S-D• Multiplicative: Upward Scenario = u*S, Downward Scenario = d*S

Multiplicative model preferred because• Value cannot go negative if u,d>0• Value increment proportional to current value (state dependence)


Modelling the underlying

Convergence of additive model to normal distribution• Central limit theorem

Convergence of multiplicative model to log-normal distributionLet Xt be the rate of change of value during t-th period

Sn =S0 *X1 *….* Xn

ln(Sn/S0 )= ln(X1)+….+ln(Xn)

Central limit theorem: ln(Sn/S0 ) is close to normal if Xt’s are independent r.v.’s

Multiplicative binomial lattice is the prevalent model for stock prices

• Corresponding valuation of financial option with the stock price as underlying is the same as Black-Scholes formula


Martingale property

Current value of the underlying = our expectation of its future value given that we are in the current state

St=E(St+1|St)

In lattice model need to make sure that this is the case for each “atom” of the lattice

S

p1

p2

pn

u1*S

u2*S

un*S

.

.

.


Martingale property

Multiplicative binomial lattice upwards at factor u and probability p, downwards with factor d and probability 1-p

Binomial lattice with expected growth at rate (1+r)

Martingale property: Value today will be expected value in the next period discounted at growth rate

du

dppdup

1

1)1(

du

drprpdup

1

1)1(


Martingale property

Multiplicative trinomial lattice with upwards scenario growth factor u>1 and probability p, downwards scenario growth factor d=1/u <1 and probability q, and growth of expected rate (1+r) with probability 1-p-q

Martingale property (assuming expectation grows at rate r)

Can use u and p as free parameters, provided the calculated q as well as 1-p-q are non-negative

• If r=0 then this amounts to 0<=p<=1/(u+1)

ru

uupqrqp

u

qpu

111


First Part of Biotech Case(No Contract Valuation, yet)

You will need BiotechCase.xls

Documents

Risk Management & Real Options IX. The Value of Phasing Stefan Scholtes Judge Institute of Management University of Cambridge MPhil Course 2004-05