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

2. 2 September 2004 © Scholtes 2004Page 2 Course content I. Introduction II. The forecast is always wrong I. The industry valuation standard: Net Present Value II. Sensitivity analysis III. The system value is a shape I. Value profiles and value-at-risk charts II. SKILL: Using a shape calculator III. CASE: Overbooking at EasyBeds IV. Developing valuation models I. Easybeds revisited V. Designing a system means sculpting its value shape I. CASE: Designing a Parking Garage I II. The flaw of averages: Effects of system constraints VI. Coping with uncertainty I: Diversification I. The central limit theorem II. The effect of statistical dependence III. 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

3. 2 September 2004 © Scholtes 2004Page 3 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

4. 2 September 2004 © Scholtes 2004Page 4 Pharmaceutical R&D No. of new drugsR&D expense in $billion Source: Tufts Centre for the study of drug development

5. 2 September 2004 © Scholtes 2004Page 5 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

6. 2 September 2004 © Scholtes 2004Page 6 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)

7. 2 September 2004 © Scholtes 2004Page 7 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

8. 2 September 2004 © Scholtes 2004Page 8 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

9. 2 September 2004 © Scholtes 2004Page 9 What’s the value of a staged investment? Phase 1 Phase 2 Sales Phase 3 -$10 M-$80 M-$120 M-$500 M $0 $1,000 M NowYear 7Year 4Year 9 80%50% 70% Success? Time

10. 2 September 2004 © Scholtes 2004Page 10 What’s the value of a staged investment? Phase 1 Phase 2 Sales Phase 3 -$10 M-$80 M-$120 M-$500 M $0 $1,000 M NowYear 7Year 4Year 9 80%50% 70% Success? Time Traditional valuation - risk-adjusted NPV (R-NPV or ENPV) Sum of discounted cash flows weighted with probability of occurrence

11. 2 September 2004 © Scholtes 2004Page 11 What’s the value of a staged investment? Phase 1 Phase 2 Sales Phase 3 -$10 M-$80 M-$120 M-$500 M $0 $1,000 M Traditional valuation - risk-adjusted NPV (R-NPV or ENPV) Sum of discounted cash flows weighted with probability of occurrence NowYear 7Year 4Year 9 80%50% 70% Success? Time -$10 -80% * $80 -80%*70% * $120 +80%*70%*50% * $(1000-500) = -$1.2

12. 2 September 2004 © Scholtes 2004Page 12 What’s the value of a staged investment? Phase 1 Phase 2 Sales Phase 3 -$10 M-$80 M-$120 M-$500 M $0 $1,000 M What if sales / cost projections change during development? NowYear 7Year 4Year 9 80%50% 70% Success? Time

13. 2 September 2004 © Scholtes 2004Page 13 What’s the value of a staged investment? Phase 1 Phase 2 Sales Phase 3 -$10 M-$80 M-$120 M-$500 M $0 Projected Sales NowYear 7Year 4Year 9 80%50% 70% Success? Time $1,400 $1,600 $400 $800 $1,200 $1,000 $600 $800 $1,200 $1,000 50/50 chance of up or down

14. 2 September 2004 © Scholtes 2004Page 14 What’s the value of a staged investment? Phase 1 Phase 2 Sales Phase 3 -$10 M-$80 M-$120 M-$500 M $0 NowYear 7Year 4Year 9 80%50% 70% Success? Time $1,400 $1,600 $400 $800 $1,200 $1,000 $600 $800 $1,200 $1,000 50/50 chance of up or down Projected Sales 1/8 3/8 1/8 Average = $1,000

15. 2 September 2004 © Scholtes 2004Page 15 What’s the value of a staged investment? $1,400 $1,600 $400 $800 $1,200 $1,000 $600 $800 $1,200 $1,000 50/50 chance of up or down NowYear 7Year 4Year 9 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

16. 2 September 2004 © Scholtes 2004Page 16 What’s the value of a staged investment? -$10 M-$80 M-$120 M-$500 M $1,400 50/50 chance of up or down $1,600 $400 $800 $1,200 $1,000 $600 $800 $1,200 $1,000 $? NowYear 7Year 4Year 9 80%50%70% Success? Time Key idea: Begin in the future and evaluate backwards

17. 2 September 2004 © Scholtes 2004Page 17 What’s the value of a staged investment? -$10 M-$80 M-$120 M-$500 M $1,400 50/50 chance of up or down $1,600 $400 $800 $1,200 $1,000 $600 $800 $1,200 $1,000 $1,100 $700 $300 $0 NowYear 7Year 4Year 9 80%50%70% Success? Time

18. 2 September 2004 © Scholtes 2004Page 18 What’s the value of a staged investment? -$10 M-$80 M-$120 M-$500 M $1,400 50/50 chance of up or down $1,600 $400 $800 $1,200 $1,000 $600 $800 $1,200 $1,000 $1,100 $700 $300 $0 $? NowYear 7Year 4Year 9 80%50%70% Success? Time

19. 2 September 2004 © Scholtes 2004Page 19 What’s the value of a staged investment? $1,200 -$10 M-$80 M-$120 M-$500 M $1,400 50/50 chance of up or down $1,600 $400 $800 $1,200 $1,000 $600 $800 $1,000 $1,100 $700 $300 $0 $130 $330 NowYear 7Year 4Year 9 80%50%70% Success? Time

20. 2 September 2004 © Scholtes 2004Page 20 What’s the value of a staged investment? 50/50 chance of up or down -$10 M-$80 M-$120 M-$500 M $1,400 $1,600 $400 $800 $1,200 $1,000 $600 $800 $1,200 $1,000 $1,100 $700 $300 $0 $130 $330 $0 $81 Now Year 7Year 4Year 9 80%50%70% Success? Time

21. 2 September 2004 © Scholtes 2004Page 21 What’s the value of a staged investment? $1,200 -$10 M-$80 M-$120 M-$500 M $1,400 50/50 chance of up or down $1,600 $400 $800 $1,200 $1,000 $600 $800 $1,000 $1,100 $700 $300 $0 $130 $330 $0 $81 $22.4 NowYear 7Year 4Year 9 80%50%70% Success? Time

22. 2 September 2004 © Scholtes 2004Page 22 What’s the value of a staged investment? $1,200 -$10 M-$80 M-$120 M-$500 M $1,400 50/50 chance of up or down $1,600 $400 $800 $1,200 $1,000 $600 $800 $1,000 $1,100 $700 $300 $0 $130 $330 $0 $81 $22.4 NowYear 7Year 4Year 9 80%50%70% Success? Time Read off optimal future decisions: Abandon after phase 1 if the downside scenario occurs, else continue whenever a phase is successful

23. 2 September 2004 © Scholtes 2004Page 23 What’s the value of a staged investment? Let’s not forget: The value of a project is a shape! Project abandonment was right in hindsight Project abandonment was wrong in hindsight

24. 2 September 2004 © Scholtes 2004Page 24 Spreadsheet analysis Model of phase-to-phase change of revenue estimates Here: 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.)

25. 2 September 2004 © Scholtes 2004Page 25 Walk away if NPV is negative. In this case value = 0 Spreadsheet analysis =MAX(E2-$E$8,0) NPV for high revenue scenario = PV of sales - investment

26. 2 September 2004 © Scholtes 2004Page 26 Spreadsheet analysis

27. 2 September 2004 © Scholtes 2004Page 27 Spreadsheet analysis R-NPV=Expected PV of future sales - investment Success probability of phase III Expected revenue if phase III is successful Cost to proceed to phase III =MAX($D$7*(50%*E10+50%*E11)-$D$8,0)

28. 2 September 2004 © Scholtes 2004Page 28 Spreadsheet analysis

29. 2 September 2004 © Scholtes 2004Page 29 Calculate R-NPV backwards as for Phase III Spreadsheet analysis

30. 2 September 2004 © Scholtes 2004Page 30 Value of the project with downstream decisions taken into account Spreadsheet analysis

31. 2 September 2004 © Scholtes 2004Page 31 What’s the value of a staged investment? R-NPV is correct if uncertainty is low or if there are no downstream decisions Option value comes from interplay between uncertainty and flexibility R-NPV=-$1.2M

32. 2 September 2004 © Scholtes 2004Page 32 What’s the value of a staged investment? R-NPV is correct if uncertainty is low or if there are no downstream decisions Option value comes from interplay between uncertainty and flexibility R-NPV=-$1.2M Key for communication: Clear connection between DCF value and Real Options value

33. 2 September 2004 © Scholtes 2004Page 33 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

34. 2 September 2004 © Scholtes 2004Page 34 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 made ̵ Launch of new product ̵ IPO for VC Options phase is riskier, capital is more expensive Apply higher discount rate during options phase and lower rate during asset phase

35. 2 September 2004 © Scholtes 2004Page 35 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

36. 2 September 2004 © Scholtes 2004Page 36 Example

37. 2 September 2004 © Scholtes 2004Page 37 What’s the value of a staged investment? Phase 1 Phase 2 Sales Phase 3 -$10 M-$80 M-$120 M-$500 M $0 $1,000 M NowYear 7Year 4Year 9 80%50% 70% Success? Time Discounted forward to year 9 at “options discount rate” Discounted backwards to year 9 at WACC

38. 2 September 2004 © Scholtes 2004Page 38 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

39. 2 September 2004 © Scholtes 2004Page 39 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)

40. 2 September 2004 © Scholtes 2004Page 40 A bit more about the mechanics…

41. 2 September 2004 © Scholtes 2004Page 41 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)

42. 2 September 2004 © Scholtes 2004Page 42 Modelling the underlying Convergence of additive model to normal distribution Central limit theorem Convergence of multiplicative model to log-normal distribution Let X t be the rate of change of value during t-th period S n =S 0 *X 1 *….* X n ln(S n /S 0 )= ln(X 1 )+….+ln(X n ) Central limit theorem: ln(S n /S 0 ) is close to normal if X t ’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

43. 2 September 2004 © Scholtes 2004Page 43 Martingale property Current value of the underlying = our expectation of its future value given that we are in the current state S t =E(S t+1 |S t ) In lattice model need to make sure that this is the case for each “atom” of the lattice S p1p1 p2p2 pnpn u 1 *S u 2 *S u n *S......

44. 2 September 2004 © Scholtes 2004Page 44 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

45. 2 September 2004 © Scholtes 2004Page 45 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)

46. 2 September 2004 © Scholtes 2004Page 46 First Part of Biotech Case (No Contract Valuation, yet) You will need BiotechCase.xls