Valuing new drug R&D project under economic fluctuation, technical risks and subjective uncertainty

Abstract

In the process of research and development (R&D) projects on new drugs, firms must face many challenges. The most serious challenges mainly come from economic fluctuations, technical risks, uncertainty of decision-maker’s subjective judgment. Troubled by these uncertain factors, how we can accurately evaluate new drug R&D projects is a very urgent and necessary problem for the management of firms. In this paper, we present a new value model on a compound real option to evaluate the new drug R&D project under economic fluctuations, technical risks and subjective uncertainty. The randomness and fuzziness of economic fluctuations are modeled by a standard fractional Brownian motion and a trapezoidal fuzzy stochastic process, respectively. The technical risks are expressed by a Poisson-type jump process, which allows for the catastrophic impact of the technical risk and thus abandonment of the new drug R&D project. The uncertainty of decision-maker’s subjective judgment is characterized by a mean value with the possibility–necessity weight, the pessimistic–optimistic index and the fuzzy risk aversion index. By using the real options approach, we achieve analytic solutions for the value models of new drugs R&D projects. A case study and analysis is also employed to emphasize the practical application of this innovative value model. We show that the uncertainties have a significant impact on the new drug R&D option value to some extent. Moreover, from the case of sensitivity analysis, some results are presented to illustrate that the value of new drug R&D project is increasing with respect to the right fuzzy factor and decreasing with respect to the left fuzzy factor, the technical risk of discovery phase, the technical risk of pre-clinical phase and the technical risk of clinical phase.