Returns to R&D Investment
- Example: Merck & GAMMA (Biotech)
- Partnership to Develop New Technology
- Initial payment $2million
- Option: $10 million in 2-3 years.
- NPV inappropriate due to uncertainty.
- Possess option characteristics
- Use BS to calculate option value
- Exercise Price: capital investment in 2-3 years.
- Stock Price: PV of cash flow from projects
- Time to Expiration: 2 to 3 years
- Project volatility: SD of returns for biotech stocks
- Risk free rate: T-bills
- Option Value > Upfront Investment, so proceed.