R & D project valuation considering changes of economic environment: A case of a pharmaceutical R & D project

R & D project valuation is important for effective R & D portfolio management through decision making, related to the firm's R & D productivity, sustainable management. In particular, scholars have emphasized the necessities of capturing option value in R & D and developed methods of real option valuation. However, despite suggesting various real option models, there are few studies on simultaneously employing mean-reverting stochastic process and Markov regime switching to describe the evolution of cash flow and to reflect time-varying parameters resulting from changes of economic environment. Therefore, we suggest a mean-reverting binomial lattice model under Markov regime switching and apply it to evaluate clinical development with project cases of the pharmaceutical industry. This study finds that decision making can be different according to the regime condition, thus the suggested model can capture risks caused by the uncertainty of the economic environment, represented by regime switching. Further, this study simulates the model according to rate parameter from 0.00 to 1.00 and risk-free interest rates for regimes 1 and 2 from (r₁ = 4%, r₂ = 2%) to (r₁ = 7%, r₂ = 5%), and confirms the rigidity of the model. Therefore, in practice, the mean-reverting binomial lattice model under Markov regime switching proposed in this study for R & D project valuation contributes to assisting company R & D project managers make effective decision making considering current economic environment and future changes.