Working Paper: NBER ID: w10114
Authors: Eduardo S. Schwartz
Abstract: This article develops and implements a simulation approach to value patents and patent-protected R&D projects based on the Real Options approach. It takes into account uncertainty in the cost-to-completion of the project, uncertainty in the cash flows to be generated from the project, and the possibility of catastrophic events that could put an end to the effort before it is completed. It also allows for the possibility of abandoning the project when costs turn out to be larger than expected or when estimated cash flows turn out to be smaller than anticipated. This abandonment option represents a very substantial part of the project's value when the project is marginal or/and when uncertainty is large. The model presented can be used to evaluate the effects of regulation on the cost of innovation and the amount on innovative output. The main focus of the article is the pharmaceutical industry. The framework, however, applies just as well to other research-intensive industries such as software or hardware development.
Keywords: patents; R&D; real options; pharmaceutical industry
JEL Codes: G31; O22; O32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| regulatory parameters (L51) | valuation of patent-protected R&D projects (O32) |
| costs exceed expectations (H51) | abandonment of R&D projects (O32) |
| cash flows fall short (G32) | abandonment of R&D projects (O32) |
| increased uncertainty in costs (D89) | higher value of the project (H43) |
| option to abandon a project (H43) | substantial value of the project (H43) |
| uncertainty is high (D89) | value of the abandonment option (J17) |