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 tobe generated independently of each other. This assumption can be unrealistic in manyapplied problems, pharmaceutical R&D included. We present a valuation proceduredealing with dependent success probabilities and random development stage times.This greater flexibility allows a better description of the sequence of decision stagesand results, which in turn, impact the value of the considered project. The theoreticalresults are illustrated through a numerical example that shows the implementation ofthe model to a pharmaceutical R&D problem