The management team of a four year old pharmaceutical company in Boston is developing an immunization against malaria. The team has just learned from the FDC that is has passed stage II (clinical) trials and will be able to move on to stage III. The expected net present value of the malaria drug as of today is estimated to be $600 million, if the firm succeeds in producing the drug. The research for the Stages I and II was entirely funded through a government grant.

The management team now has to raise outside capital to pass stage III. For that purpose, the CEO would like you to do a valuation of the company using real options pricing. Please assume that the discount rate for this project is 20% and use the data in the table below to model the real option. Assume that the costs for each stage have to be paid prior to starting the individual stage.

Comparable Statistics Sources: Lehman Brothers 2002, Biopharm 1999, Paraxel's Statistical Yearbook 2006

 Phase                          Average Duration       Probability to reach next phase           Cost

II (clinical)                              5 years                         25%                                         $100M

III (FDA)                                2 years                         33%                                         $40M

1. Please explain how you would set up the valuation as a real option. What is the valuation of the company?