TABLE OF CONTENTS The real options examples presented up to this point involved market uncertainty and contingent decisions related to the resolution of that uncertainty. Many projects, however, face both market and private uncertainties, as discussed in Chapter 3. For an oil company, the market uncertainty surrounding the price of oil dictates the revenues from an unexplored oil field, whereas the yield from the site is subject to private uncertainty. The uncertainty related to the effectiveness of a new technology is private, and the probability of commercial success is market driven. Similarly, the efficacy of an experimental drug is subject to private uncertainty, whereas its sales are controlled by the market. In all these cases, it becomes necessary to account for the private risk along with the market risk in the ROA during project valuation. The following example illustrates how decision tree analysis (DTA) can incorporate private uncertainty into ROA, thereby providing an integrated framework for valuation of projects that exhibit both private and market uncertainties.
Easy BooTox specializes in novel drug delivery techniques. It recently developed a skin patch that can deliver the drug BooTox transdermally, the-state-of-the-art delivery technique, and hence avoid the pain of injections. Before the product can be launched, the company needs to conduct large-scale clinical trials to prove the efficacy of the new technique and win FDA approval. There is private risk in both these steps that can lead to the abandonment of this project. The company estimates an...
