Building on the
principles of expected NPV (ENPV) calculations, Monte Carlo simulation is an evaluation technique which attempts to model all
possible project outcomes subject to uncertainty. It introduces more
sophisticated modeling techniques replacing discrete choice decision trees
with continuous distributions of possible outcomes. In this way a more
representative reflection of possible market events is produced. Monte Carlo
simulation also looks to present outcomes as a probability set of all possible
outcomes rather than as a probability adjusted average outcome as with ENPV
calculations.
When
the Monte Carlo simulation approach is applied to licensing agreements the benefits of the use of continuous rather discrete
distributions of probabilities and results can be seen. The single inputs for
the likelihood of success in research and development trials are replaced by
distributions of likely outcomes, modeled from historical results and data.
For forecast marketing revenues, single inputs are again replaced by a
distribution of likely results, modeling various contingent inputs and again
using historical data and trends. The resulting distribution of NPV values for
the licensing agreement provides both a likely mean value, as well as the
likelihood that the NPV is greater than zero.
By
applying a Monte Carlo distribution it
can be shown that in agreements valued to have a mean NPV value close to zero,
the probability of generating a positive NPV from the licensing agreement
based on associated research, development and marketing risks can be as low as
20%. This important information is hidden by the use of expected NPV
calculations.
Licensing
case study – Monte Carlo simulation
Mean
NPV ≈
$0m (using a discount rate of 10%)
Probability
NPV>0 ≈ 20% (using
a discount rate of 10%)
Where
Monte Carlo simulation recognizes the technological and market uncertainties
neglected by NPV, real option approaches add the possibility of flexibility,
or a flexible response. The staged investments typically made in licensing
agreements are valued by assimilating the agreement’s payment structures and
risks with common financial options. Since licensing payments and investment
decisions are contingent on risky project outcomes, the value of this project
management flexibility can be evaluated by looking at the valuation of similar
contingent payment structures traded in the investment community.
The
most common method applied for the valuation of real options is to replicate
payment structures through call and put options. The contingent payments and
rewards for a pharmaceutical company are similar to those of the owner of a
call option on shares. If when phase III clinical trials are completed the
compound has proven to have a positive profile for marketing a pharmaceutical
company will continue investments to bring the drug to market, if not it will
abandon the compound. Similarly the owner of the share option will exercise
his or her right to buy shares at a given price if the share value has risen
above the exercise price. In an extension of the framework applied in ENPV and
Monte Carlo, real options do not simply calculate the probability of projects
failing, they incorporate this into the evaluation as well as the rational
decision by a company to abandon subsequent investments on a loss making
project.
Licensing
case study – Real options evaluation
Real option value = $0.4m (varying the discount rate subject to relative risk)
Based on the
illustrated licensing agreement case study, the real options framework
incorporates the in-licensers abandonment option in year two to chose not to
launch the product if the likely present value of profits less royalty
payments falls below the one off $130m manufacturing milestone payment made to
the compound originator on product launch. Varying the discount rate
appropriately throughout the decision tree to reflect relative risk levels the
real options valuation of the licensing contract for the in-licenser is $0.4m,
representing a positive investment appraisal. The real options calculation
illustrates that when a licensing contract involves contingent payments and
management flexibility a positive real options appraisal can be hidden by a
negative ENPV.
Independent Strategic Decision
Analysis 
