Real-Option Valuation and Decision Tree Analysis  785
DTA Approach: Technological Risk
The DTA approach presented next follows the four steps for the valuation of 
flexibility as described in the previous section. In the DTA valuation of the 
research and development project, we consider only the prevailing techno-
logical risk relating to the research and testing outcomes. The commercial risk 
concerning the future profitability of the drug and the technological risk are 
taken into account jointly in the ROV approach discussed in the next section.
Step 1: Estimate Present Value without Flexibility  If the development pro-
cess succeeds, the drug will deliver substantial value in six years’ time. Mar-
gins in the pharmaceutical industry are high because patents protect drugs 
against competition. A successful drug is expected to generate annual sales 
of $2,925 million and 45 percent earnings before interest, taxes, depreciation, 
and amortization (EBITDA) margin on sales until its patent expires, ten years 
after its market launch. (Because prices decline drastically after a patent ex-
pires, we do not count cash flows beyond that time.) Assuming a 30 percent 
tax rate and a 7 percent cost of capital, a marketable drug’s present value at 
the launch date would therefore be $6,475 million. Unfortunately, the odds of 
successful development are small. The cumulative probability of success over 
the research and testing phase is only 6 percent (0.15 for research × 0.40 for 
testing). In addition, the investments needed to develop, test, and market a 
drug are high: $100 million in the research phase, $250 million in the testing 
phase, and $150 million in marketing.
If we had to commit to all three investments today, we should not proceed, 
because the NPV would be negative:
Standard NPV
PV Expected Cash Flows
PV Investments
0
0
0
0 06
=
−
=
(
)
(
)
.
$6 475
1 07
100
250
1 05
150
1 05
169
6
3
6
,
.
$
$
.
$
.
$
(
)








−
−
(
)
−
(
)
= −
However, if we take into account management’s ability to abandon the project 
before completion, the value is significantly higher.
Step 2: Model Uncertainty Using an Event Tree  For this development 
project, you can model the prevailing technological risk using a straightfor-
ward event tree (see Exhibit 39.15). The expected value of a marketable drug 
after successful development is shown at its DCF value of $6,475 million as 
of t = 6.
Step 3: Model Flexibility Using a Decision Tree  Next, include decision flex-
ibility in the tree, working from right to left. At the end of the testing phase, 
we have the option to invest $150 million in marketing to launch the product. 

786  Flexibility
We should invest only if testing has produced a marketable product. At the 
end of the research phase, we have the option to proceed with the testing 
phase. We proceed to testing only if the payoffs justify the incremental invest-
ment of $250 million.
Step 4: Estimate Value of Flexibility  Because the technological risk is fully 
diversifiable, apply a straightforward DTA approach for the valuation of flex-
ibility. Again, work from right to left in the tree (see Exhibit 39.16). After six 
years, at the end of the testing phase, we proceed with launching the product 
only if there is a marketable product. The value in millions at this point in time 
is therefore NPV6 = Max[($6,475 – $150), 0] = $6,325. At the end of the research 
EXHIBIT 39.15  Event Tree: R&D Option with Technological Risk
$ million
Success
Failure
Success
Failure
PV6 (Drug) = 6,475 
Invest 6 
 = (150)
p = 15%
1 – p = 85%
p = 40%
1 – p = 60%
Invest 3 = (250)
Stop
Stop
Invest 0 = (100)
Research phase
Testing phase
Marketing
Technological risk event
Decision event
Note: PVt = present value of marketable drug as of year t 
 
 
  p = probability of technological success
EXHIBIT 39.16  Decision Tree: R&D Option with Technological Risk
$ million
Research phase
Testing phase
Marketing
Success
Failure
Success
Failure
NPV*3 = 2,062
NPV3 = 0 
NPV*6 = 6,325
NPV*6 = 0 
p = 15%
1 – p = 85%
p = 40%
1 – p = 60%
NPV*0 = 120
NPV3 = 1,815
NPV3 = 0 
NPV6 = 6,325
NPV6 = 0 
NPV0 = 122
Technological risk event
Decision event
Note: NPVt = net present value as of year t 
    NPV* = contingent NPV 
        p = probability of technological success