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References
Copeland, T., Koller, T., and Murrin, J. 1996. In Valuation: measuring and managing the value of companies, 2nd ed., John Wiley & Sons, New York.
For a more formal and extended discussion of corporate finance and a review of the NPV model, see Brealey, R.A., and Meyers, S., Principles of corporate finance, 5th ed. McGraw-Hill, New York, or Ross, S., Westerfield, R., and Jaffe, J., Corporate finance, 4th ed., Irwin Publishers, New York.
Luehrman, T.A. 1997. Harvard Bus. Rev. 75: 132–142.
After-tax operating cash flows (ATOCFs) are equivalent to after tax operating income adjusted for invested capital.
From the firm's perspective a project should be undertaken only if its expected return is greater than an asset of comparable risk.
When companies are financed with both debt and equity the discount rate used in research and development project valuations should reflect the weighted average cost of capital.
The modern portfolio theory indicates that any asset must be viewed as part of a portfolio of assets, with the risk of each project being its contribution to the risk of the portfolio. This measure of risk is represented by a beta value (βA), which is the standardized covariance of an asset's return with the return on the market portfolio. In the above discussion, the asset could represent either a project or the entire firm.
Alternatively, when specific information regarding project attributes is unavailable, companies can use data compiled from projects involving similar classes of therapeutic compounds to determine a probability distribution. For example, probabilities relating to asset survival may be 20%, 65%, 40%, 68%, 85%, and 92% for each stage, respectively. Although the weighted probability contains information regarding the asset survival, and is therefore inclusive of both the risk and timing of the biotechnology cash flows, it is not the same as the discount factor derived by using the CAPM. ATOCFs that are derived using the weighted probability of asset survival should be discounted at the risk-free rate of return. Discounting the ATOCFs that result from the weighted average probability by the corporate cost of capital or the corresponding stage-specific discount factor will be “double counting” the risk associated with the project. This practice will result in the concomitant overestimation of risk and the underestimation of value for a given project's anticipated revenues.
One such approach takes advantage of the obvious similarities that exist between an irreversible investment decision and a financial call option. Option pricing models such as those developed by Black and Scholes in 1973 (reviewed in ref. 2) have been revised for the analysis of projects as real options. Recently, significant effort has been directed at the design and implementation of these strategies for the valuation of capital investment projects.
Dixit, A. K. and Pindyck, R.S. 1995. Harvard Bus. Rev. 73: 105–115.
Luehrman, T.A. 1994. Harvard Bus. School Case Study #9-295-074.
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Nelson, T., Mukherji, A. Valuing biotechnology assets. Nat Biotechnol 16, 525–529 (1998). https://doi.org/10.1038/nbt0698-525
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DOI: https://doi.org/10.1038/nbt0698-525
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