A drug company is considering developing a new drug. Due to the uncertain nature of the drug's progress in development, market demand, success in Shuman and animal testing, and FDA approval, management has decided that it will create a strategic abandonment option. That is, anytime within the next two years, management can review the progress of the R&D effort and decide whether to terminate the development of the drug. If the program is terminated, the firm can sell off its intellectual property rights to the drug to another pharmaceutical firm.
• The present value of the expected future cash flows (discounted at an appropriate market-adjusted rate) is $150 million.
• A Monte Carlo simulation indicates that the volatility of the returns on future cash flows is 30%.
• The risk-free rate on a riskless asset for the same time frame is 5%.
• The drug's patent is worth $100 million if sold within the next two years.
Given that S = $150, σ = 30%, T = 2, and the -free interest rate (r) = 5%, determine the value the abandonment option if the following state-ts are true.
(a) It is an American option using a binomial lattice approach.
(b) Suppose that the R&D program was indeed successful at the end of two years, and the present value of the expected future cash flows discounted at an appropriate market risk-adjusted discount rate is found to be $400 million. The implied volatility of the returns on the projected future cash flows to be 35%. The risk-free rate is 7% for the next two years. Suppose that the firm has the option to expand and double its operations by acquiring its competitor for a sum of $250 million at any time over the next two years. What is the total value of the project to this firm, assuming you account for this expansion option?