Valuation of R&D compound option using Markov chain approach

Incorporation of technical risk in compound real options has been considered in Cassimon et al. (2011) concerning the valuation of multi-stage pharmaceutical R&D. There, the technical success probabilities at each development stage were assumed to be generated independently of each other. This assumption can be unrealistic in many applied problems, pharmaceutical R&D included. We present a valuation procedure dealing with dependent success probabilities and random development stage times. This greater flexibility allows a better description of the sequence of decision stages and results, which in turn, impact the value of the considered project. The theoretical results are illustrated through a numerical example that shows the implementation of the model to a pharmaceutical R&D problem.