Real options valuation of a biotech project using fuzzy numbers

Anders Rasmus Enevoldsen & Anders Vinderslev Nordbæk

Student thesis: Master thesis


The purpose of this thesis is to introduce the concept of real option valuation with the use of fuzzy numbers through performing different fuzzy real option valuations on a constructed biotech drug development project. The main argument among practitioners for not applying a real option approach is the difficulty of implementation. The fuzzy pay-off method to real option valuation sees to this and makes real option valuation accessible for practitioners with a non-financial background. In the first part of the thesis the underlying assumptions for performing a fuzzy valuation in a biotech setting are reviewed, discussed and concluded on. First the current business environment as well as the valuation practices most commonly applied is examined. The most used DCF method is criticized as it does not incorporate the value of managerial flexibility stemming from the high uncertainty surrounding a biotech project. To include this value, an analysis of the classic real option valuation methods best suited for a biotech setting is then performed, the result of which is that the event tree and the binomial tree are well suited for applying a real option approach to the valuation – dependent on the practitioner’s financial level. Next the concept of fuzzy numbers is introduced. The fuzzy pay-off method to real option valuation is presented and applied to simple DCF valuations in an uncomplicated manner in order to transform it into a real option valuation. Also a fuzzy approach to a binomial tree valuation is analysed and applied. The last part is centered on the actual valuation of the constructed biotech project. The valuation setting is outlined and analysed in order to provide reliable input variables for the valuation. Through strategic analyses and empirical findings the capital budgeting is performed to allow three different valuations aimed at different levels of financial understanding to be performed. First, the fuzzy pay-off method is applied to the traditional DCF valuation. It is shown how the fuzzy approach creates a real option valuation that captures the value of managerial flexibility neglected by the traditional. Second, the fuzzy pay-off method is adopted on the risk adjusted event tree valuation and again demonstrates its ability to value managerial flexibility compared to the original approach. Third, fuzzy numbers are applied to a binomial tree valuation, where the fuzzy version puts more weight on the managerial flexibility stemming from the amplified volatile development in the underlying asset. Compared to the fuzzy DCF valuation the fuzzy risk adjusted valuation is preferred due to its inclusion of a structured risk perspective and ease of implementation for practitioners. For more advanced practitioners the fuzzy binomial approach is preferred due to its superior alignment with the real option thinking.

EducationsMSc in Applied Economics and Finance, (Graduate Programme) Final Thesis
Publication date2011
Number of pages158