Innovations, real options, risk and return, evidence from the pharmaceutical and biotechnology industries

...  Innovations, Real Options, Risk and Return: Evidence from the Pharmaceutical and Biotechnology Industries, ” a dissertation prepared by Azizjon Alimov in partial fulfillment of the requirements for the. .. Finance for the degree o f Doctor o f Philosophy to be taken September 2007 Title: INNOVATIONS, REAL OPTIONS, RISK AND RETURN: EVIDENCE FROM THE PHARMACEUTICAL AND BIOTECHNOLOGY INDUSTRIES Approved:... flows from the project at different stages of the project The first row gives the value of the project and the second row gives the risk premium of the project (annualized expected return minus risk- free

THE PHARMACEUTICAL AND BIOTECHNOLOGY INDUSTRIES

byAZIZJON ALIMOV

A DISSERTATIONPresented to the Department of Finance and the Graduate School of the University of Oregon

in partial fulfillment of the requirements

for the degree of Doctor of PhilosophySeptember 2007

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and Biotechnology Industries,” a dissertation prepared by Azizjon Alimov in partial fulfillment of the requirements for the Doctor of Philosophy degree in the Department of Finance This dissertation has been approved and accepted by:

Dr Wayne Mikkelson, Chair of the Examining Committee

Azizjon Alimov for the degree o f Doctor o f Philosophy

in the Department o f Finance to be taken September 2007Title: INNOVATIONS, REAL OPTIONS, RISK AND RETURN: EVIDENCE FROM THE PHARMACEUTICAL AND BIOTECHNOLOGY INDUSTRIES

Approved: _

Dr Wayne Mikkelson

Based on recently developed real options models, such as in Berk, Green and Naik (1999, 2004), I develop and test hypotheses about the impact o f growth options embedded in innovative investment on the risk and the expected return o f a firm’s equity

I test my hypotheses using a hand-collected dataset on the major innovation activities undertaken by pharmaceutical and biotech firms over the period 1985-2004 The dataset contains detailed information on 112 innovation-targeted acquisitions, 273 highly- innovative drug introductions and 211 key patent grants underlying these drugs

I find significantly positive abnormal stock returns around the announcements o f patent and new drug applications and approvals, and negative abnormal stock returns around acquisition announcements These results suggest that innovative events provide value-relevant information to the stock market To examine whether changes in firm value around the events are in part due to predicted revisions in expected return on

results are mixed I find that patent-related events are followed by positive abnormal returns, which is consistent with the prediction that investors require higher return following the discovery o f a relatively risky growth option However, I find that new drug applications are also followed by positive abnormal returns, which contradicts the prediction that expected returns decline following the conversion o f a growth option into relatively safe assets in place.

I then examine the central prediction o f the real options models that the new information about growth options affects expected returns by changing a firm’s equity risk

I do not find that the events significantly affect the systematic risk o f innovating firms Furthermore, changes in the systematic risk do not explain abnormal returns around the event announcements Taken together, these results do not support the main prediction of real options theory that the systematic risk and hence the expected return o f individual firms change in a predictable manner in response to information about growth options embedded in innovative investment

CURRICULUM VITAE NAME OF AUTHOR: Azizjon Alimov

GRADUATE AND UNDERGRADUATE SCHOOLS ATTENDED:

University of OregonCentral Michigan UniversityBanking and Finance Academy, UzbekistanSamarkand Cooperative Institute, Uzbekistan

DEGREES AWARDED:

Doctor of Philosophy, Finance, 2007, University of Oregon Master of Business Administration, 2001, Central Michigan University Master of Science, Economics, 1998, Banking and Finance Academy, Uzbekistan Diploma of Economist, Samarkand Cooperative Institute, Uzbekistan

AREAS OF SPECIAL INTEREST:

Corporate Finance InvestmentsCorporate Investment Decisions and Asset Prices

I gratefully acknowledge the advice and support of my dissertation committee, Bruce Blonigen, John Chalmers, Megan Partch, and especially Wayne Mikkelson (chair) Their guidance and encouragement are ultimately responsible for this dissertation I also wish to thank Jonathan Berk, Ro Gutierrez, Ilan Guedj, Ron Giammarino, and seminar participants at the University of Oregon, the 2006 FMA Doctoral Seminar in Salt Lake City, and California State University, Fullerton for their helpful comments I thank the University of Oregon and the Hopewell/Racette Scholarship for financial support.

TABLE OF CONTENTS

I INTRODUCTION 1

II THEORETICAL PERSPECTIVES 12

Real Options Models and Innovative Investment 12

Empirical Im plications 17

The Effect of Competition and Business Cycle 23

III THE PHARMACEUTICAL AND BIOTECHNOLOGY INDUSTRIES 27

Background 27

Patent Applications and A pprovals 32

New Drug Applications 33

Innovation-Targeted Acquisitions 34

IV SAMPLE SELECTION AND VARIABLE CONSTRUCTION 35

Sample Selection 35

Dataset Construction 39

Information on New Drug Innovations 39

Information on Patents 44

Information on Innovation-Targeted Acquisitions 46

Independent Variables: Equity Risk and R etu rn 49

Control Variables 53

V EMPIRICAL ANALYSIS 58

Descriptive Statistics of Innovative Investment E v en ts 58

Abnormal Announcement R eturns 64

Medium-Horizon Post-Event Abnormal Returns 70

Changes in Risk Around Innovative Investment E vents 78

Returns and Changes in Risk 86

Chapter Page

Returns, Risk Changes and Growth O ptions 93

Discussion 100

VI CONCLUSIONS 103

APPENDICES 106

A VALUE AND RISK OF THE INNOVATIVE PROJECT OVER TIME 106

B SAMPLE NEWS REPORTS 107

BIBLIOGRAPHY 109

LIST OF FIGURES

1 Timeline of Events and Predicted Changes in Risk and Returns 19

2 Estimates of Time and Cost o f Innovative Drug Development 30

3 Average Raw and Risk-Adjusted Returns for the Three Categories ofFirms in Event T im e 74

LIST OF TABLES

1 List of Sample F irm s 36

2 Temporal Distribution of Innovative Investment E vents 59

3 Descriptive Statistics 60

4 Announcement Period Abnormal Returns 67

5 Medium-Horizon Post-Event Abnormal R eturns 73

6 Changes in Systematic and Idiosyncratic Equity R isk 81

7 Regression of Returns on Changes in Risk Controlling for Firm Characteristics: Patent Applications 89

8 Regression of Returns on Changes in Risk Controlling for Firm Characteristics: Drug Applications 90

9 Regression of Returns on Changes in Risk Controlling for Firm Characteristics: Innovation-Targeted Acquisitions 91

10 Regressions of Returns and Risk Changes on Growth Options and Firm Characteristics: Patent A pplications 97

11 Regressions of Returns and Risk Changes on Growth Options and Firm Characteristics: Drug Applications 98

12 Regressions of Returns and Risk Changes on Growth Options and Firm Characteristics: Innovation-Targeted Acquisitions 99

CHAPTER I INTRODUCTION

I investigate whether information about real options embedded in a firm’s innovative investment affects the risk and expected return of a firm’s equity An increasingly important component of many firms’ portfolio of projects is technological innovations, which can potentially generate new products and markets Innovations in turn are the result of deliberate multi-stage research and development activities, which are usually characterized by multiple sources of uncertainty about the potential benefits and costs of the investment Because an innovative project involves a sequence of contingent investment decisions, the project can be viewed as a compound real option

on the variables underlying the project value, such as the expected time and costs to completion and the stream of cash flows after completion These options can have substantial economic value by generating future decision rights for a firm As reviewed below, real options theory claims that information about the growth options embedded

in a firm’s innovative investment plays an important role in determining the required return of a firm’s equity

One area to which my study contributes is a relatively recent but rapidly growing literature that applies real options methods to corporate finance and asset pricing problems The theory of real options recognizes that firms represent continuously evolving portfolios of ongoing projects and growth options to invest in new projects Berk, Green and Naik (1999, 2004), Gomes, Kogan, and Zhang (2003),

and Carlson, Fisher, and Giammarino (2004, 2006) theoretically demonstrate that a firm's systematic risk, and hence its expected return, reflect the firm’s exposure to the systematic risks of assets in place and growth options The relative distribution of assets

in place and growth options changes with the external acquisition and internal development of new growth options, the exercise of growth options as well as with other investment decisions Therefore, a critical implication of the real options models

is that important investment events will have a direct impact on the risk and required return for a firm’s equity

Despite the theoretical development of real options theory, little empirical evidence documents the impact of real options on firms’ equity risk and expected return Existing studies, which have examined some of the implications of real options theory, lack necessary firm-level data and are able to provide only indirect evidence.For example, Anderson and Garcia-Feijoo (2006) and Xing (2006) document an association between the capital investment rate, a proxy for the exercise of growth options, and the information contained in the Fama and French (1993) size and book-to- market portfolios Carlson et al (2005) document an increase in firms’ beta prior to seasoned equity offerings and a decrease thereafter, and argue that this result is generally consistent with a real options explanation of stock underperformance following seasoned equity offerings In contrast, my paper directly tests the empirical implications of real options theory by identifying discrete instances of the discovery and exercise of growth options and relating the economic characteristics of these options to changes in the measures of firms' equity risk and return around the event In addition, I

options that could be financed from multiple sources.

My paper also contributes to the literature that studies the stock return implications of firms’ innovative activities While real options models argue that movements in the market valuation of such firms reflect the time-varying exposure of firms to risks of growth options, there has been popular support for the notion that the market participants often misreact to innovation news with uncertain economic value Most of the studies in this area examine the association between accounting data on firms’ research activities and subsequent stock returns For example, Chan, Lakonishok, and Sougiannis (2001) and Eberhart, Maxwell, and Siddique (2004) report a positive association between the level of and changes in R&D investment and subsequent abnormal stock returns These studies conclude that the market underreacts to the potential benefits from the firms’ research activity Daniel and Titman (2006) find that a stock’s future return is unrelated to the firm’s past accounting-based performance and negatively related to the firm’s past non-accounting based performance They argue that this is evidence that investors overreact to intangible information, such as information about the firm’s growth options In contrast, my goal is to deepen our understanding of how firms’ innovative activities affect the expected return on their equity in two ways First, building on real options theory I propose and examine the hypothesis that

innovative events are associated with significant changes in firms’ cost of equity capital, and that these changes can explain the pattern of abnormal returns around the event Real options theory implies that ignoring growth options embedded in most

I test whether changes in risk and return around the innovative investment events are related to the properties of growth options embedded in these investments These results should help distinguish between the risk and investor misreaction stories Second, I examine a wider class of innovation events than has been examined and measure information about innovation events directly from its source Therefore, my tests are arguably more direct and should provide meaningful additional evidence.

Rather than studying the implications of real options theory in a variety of industries, however, I focus on innovative investments of firms in the pharmaceutical and biotechnology industries While my focus on firms within the same industry restricts the generality of results, it has four advantages First, the pharmaceutical and biotechnology industries are one of the most research-intensive industries in the U.S and real options represent a significant portion of pharmaceutical and biotech firms’ value The real options of these firms are clearly demarked and come in the form of new patents and drugs created by substantial investment in research and development

Second, the theoretical literature makes specific predictions as to the effects of a pharmaceutical firm’s drug research and development activity on the expected return on its equity In particular, Cornell (1999) and Berk, Green and Naik (2004) demonstrate how a pharmaceutical firm’s progress towards completion of a drug development project drives the required return for a firm’s equity Third, due to the Federal Drug and Food Administration regulation, a great deal of data is available on the activities related

to the discovery and development of growth options by biotech and pharmaceutical

completion of the project, such as new patent and drug applications A researcher can also obtain important value-relevant information to compute proxies for the value and risk of real options embedded in innovative investment events Other critical variables can also be identified and controlled for Finally, this approach allows me to limit the possibility of contamination of results due to mis-measurement of key variables or the effects of other variables not included in the analysis For example, it is extraordinarily difficult to obtain comparable project level data across firms As a result, the properties

of real options for a large sample of firms in different industries are likely to be measured with much error For these reasons, I believe that my sample provides the most promising setting for conducting an investigation of how a firm’s decisions related

to the development and exercise of growth options affect the risk and expected return of

Administration A patent grant provides monopoly rights to sell the drug until the patent expires and, therefore, gives the firms exclusive access to a growth option Innovation- targeted acquisitions are important means through which established pharmaceutical firms obtain new technologies and associated skills as well as promising products In sum, I argue that these events are important events in the life-cycle o f the sample firms and result in significant changes in the composition and risk of firms’ assets As a result, I expect these events to affect investors’ perception of innovator firms’ risk- retum characteristics.

I use the real option model of Berk, Green and Naik (2004) to formalize hypotheses about how these innovation events should impact the systematic and idiosyncratic equity risk and thus the expected return Their model captures different sources of risk embedded in the multi-stage innovative investment project, and the authors analyze their interaction in determining the risk premium and value of the project over its life-cycle Specifically, there is systematic risk associated with future cash flows the project can potentially produce after completion There is also

idiosyncratic risk pertaining to the uncertainty about the successful completion of the project The project involves several separate stages of development, and at each stage, the managerial decision of whether to continue the investment depends on the resolution

of systematic and idiosyncratic uncertainty Therefore, an investment project is viewed

as a compound real option on systematic uncertainty The models shows that the systematic risk, and thus the expected return, o f the project are likely greatest at the

onset, and decrease as the project approaches completion and idiosyncratic and systematic uncertainty gets resolved The intuition behind this result is that growth options, because of the implicit leverage they impart, have higher systematic risk and therefore expected returns than the asset on which it is written As a result, the model implies that important events in the project’s life-cycle that impact its value and risk premium, will also influence a firm’s systematic risk and the expected return for its stock.

In the context of my study, I expect both the patent and acquisition events to result in an increase in a firm’s equity risk and thus the expected return because these events signal to the market that a firm expands its portfolio of growth options

Conversely, I expect the drug application and approval events to decrease a firm’s equity risk and expected stock return because a firm is exercising its growth options and converting them into less risky assets in place Both predictions reflect the assumption that growth options have higher required risk premium and, hence, expected return than the assets in place when the underlying asset of the option closely mimics assets in place Finally, I hypothesize that the impact of the events on the equity risk and return

of firms depends on the intensity of product-market competition and the business cycle

I start my analysis by examining the short and medium window stock price reaction to the event announcements I conduct tests with stock returns for three reasons First, such tests permit me to directly examine the pricing effects of news about growth options Second, by studying post-event patterns of stock returns I can measure the economic compensation for the event-induced change in the systematic risk of the

should also change expected stock returns in the same direction Therefore, I expect that firms with a predicted event-induced increase in their equity risk will exhibit an

increase in their expected returns In contrast, I expect that firms with a predicted decrease in their equity risk will exhibit a decrease in their expected returns Third, by examining whether return movements following the events are explained by changes in equity risk, I can measure the violations of real options theory in economic terms

The results show that that all three innovative events have significant stock price effects and thus appear to possess substantial information content I find positive

abnormal returns to the announcements of patent grants as well as applications and approvals of new drugs For example, the average firm announcing a patent grant and a new drug approval experiences the cumulative abnormal returns of 1.45% and 2.2% over the five-day window around the event In contrast, the average firm announcing an innovation-motivated acquisition realizes a negative abnormal return of 1.9% In the medium-window tests, I find that patent-related events and applications of new drugs are followed by positive abnormal returns that last for at least nine months after the events The positive abnormal return pattern after the patent-related events is consistent with the prediction that investors require higher rate of return in response to new information about the discovery of a risky growth option However, I do not find a corresponding pattern of increasing stock returns following innovation-driven acquisitions I also do not find a pattern of stock returns moving downward following the drug applications and approvals, or the exercise of growth options, as would be the

case if the exercise of growth option were to reduce the equity risk and expected returns

of innovator firms

In order for these abnormal returns to be consistent with an efficient price formation, the level of equity risk measures in the post-event period must be different from that before the event To measure changes in the systematic risk and idiosyncratic equity risks of innovator firms, I estimate the Fama and French (1993) three-factor model at the firm-level The Fama and French model suits the purpose of my study particularly well because, according to Berk, Green and Naik (1999) and Gomes, Kogan and Zhang (2003), the size and book-to-market factors in the model capture the

components of a firm’s systematic risk attributable to its growth options and assets in place Therefore, the analysis in this paper should help us understand whether the real options story is a good description of behavior of asset prices around innovative events

The results show that, in general, firms do not experience changes in their systematic equity risk, measured as both changes in individual loadings on the Fama- French three factors and change in the overall risk premia However, I document an increase in idiosyncratic equity risk following the patent events and a decrease in idiosyncratic equity risk after the announcement of drug approval and innovation- motivated acquisitions While the observed reductions in idiosyncratic risk are economically significant, it is not clear how the changes in non-compensated risk can explain the stock return movements following the event To test the proposition that seemingly abnormal returns that follow the test events are induced by risk shifts, I estimate multivariate regressions of the post-event abnormal stock returns on the

changes in the systematic and idiosyncratic risk The results show that, in general, changes in both measures of equity risk do not explain the post-event patterns of abnormal stock returns.

My final analysis then directly examines the central prediction of real options theory that the economic properties of growth options embedded in innovative investment are the main determinants of changes in equity risk and expected stock returns around the innovation news I find that cross-sectional differences in the announcement abnormal stock returns are positively related to the relative value of growth options embedded in these events However, I do not find that economic properties of growth options are systematically related to changes in the firms’

systematic and idiosyncratic risks that follow the events

Taken together, my results are both interesting and puzzling, in particular, for the current generation of real options models The results do suggest that announcement

o f innovation news provide value-relevant information to investors, who rationally revise firms’ stock prices in response to new information about the value of the underlying growth option However, I do not find support for the central prediction of the real option theory that the new information affects expected stock returns by influencing firms’ cost of equity capital O f course, the interpretation of the tests is certainly limited by my need to use a proxy for the unobservable model of expected returns As a result, my tests are joint tests of the changes in the pricing of assets in place and growth options around the event and the Fama and French factors as priced risk factors Nevertheless, at a minimum, my results cast doubts on arguments in Berk,

the firm’s portfolio of growth options are able to explain the abnormal returns estimated using the Fama and French three-factor model Perhaps, a new asset pricing model is needed to explain the excess returns following changes in the composition of firms’ portfolios of assets.

CHAPTER II THEORETICAL PERSPECTIVES

In this section, I present the theoretical arguments for the impact of innovative investment events on firms’ equity risk, and thus the expected return on their equity The goal is to make the intuition as clear as possible by synthesizing the main arguments of this literature and my research questions Section 2.1 presents and discusses a simplified version of the real options model of Berk, Green and Naik (2004) and discuses its implications regarding the impact of growth options embedded in the innovative project on the required risk premium and expected returns of firms Section 2.2 gives an interpretation of the model in the context of biotech and pharmaceutical innovative activities and develops the empirical implications In Section 2 3 ,1 discuss how product-market competition and the business cycle, not considered in the real options models, may affect empirical results

Real Options Models and Innovative Investment The theory of real options provides a model of investment decisions involving upfront irreversible cost commitments in the face of uncertainty and the choice of incurring additional costs in the future Under these conditions, a firm’s investment policy includes rights or options, but not the obligation, to make further investments or delay such investments These investment options therefore create value for the firm by generating future decision rights Once uncertainty is reduced, a firm can then choose to

A good survey of the real options literature can be found in Dixit and Pindyck (1994) Recently, a new strand of research has emerged that uses real options theory to relate stock return dynamics to firms’ optimal investment decisions This literature, pioneered

by Berk, Green, and Naik (1999), includes Carlson, Fisher, and Giammarino (2004, 2006), Gomes, Kogan, and Zhang (2003), Berk, Green, and Naik (2004), Cooper (2006), Kogan (2004), and Zhang (2005) In this paper, I use the Berk, Green, and Naik (2004) model to develop hypotheses on the impact of real options embedded in

innovative projects on the firms’ cost of equity capital and expected returns I summarize here a simplified version of this model and its implications

The model begins when a firm starts a new project to develop a new product at time 0 The new project will generate a stream of stochastic cash flows after the firm successfully completes a number of discrete stages of research The value and risk premium of the project is determined by its idiosyncratic and systematic risk These two sources of risk allows the model to embed the capital budgeting problem in an asset pricing framework, which is suitable to address the main question of my paper The source of systematic risk of the project is uncertainty about the future cash flows after the project is completed Although the firm does not receive cash flows prior to the completion of the project, it is assumed that the firm and investors knows what the cash flows would be if the project were complete today These cash flow change as more information is obtained through investment and learning about the demand for the product The source of idiosyncratic risk is technical uncertainty regarding the

successful completion of the project, as well as the competitive threat Technical uncertainty can be resolved only through investment.

At each stage of the investment process, the decision of whether it should continue to the next stage depends on the resolution of systematic and unsystematic uncertainty This gives to the project the characteristics of a series of compound options

to invest, where the strike price of the option is the expected investment cost to complete the project and the underlying asset is the value of future cash flow Thus, the value of real options embedded in the innovative project comes from systematic and idiosyncratic uncertainty regarding future cash flows and fixed investment costs

In the model, the market value of a firm at any time is given by

Where

VALUE=the firm’s market value

A=fhe present value of the expected cash flows generated by the assets-in-

place(ongoing projects)G=operator representing an American call optionA=the present value of the expected cash flows generated by the project7=the expected investment cost required to complete the project

Consequently, the firm’s overall cost of capital or risk premium at any time reflects the firm’s exposure to risks of the assets in place and growth options, as described by

MsKim = R is k

AIP Value + Riskao

of the equations is strictly appropriate only when the values of the assets in place and the asset underlying the growth option are described by separate stochastic processes, i.e there is no interaction between the two assets

To better understand the effect of such information, however, it is necessary to discuss how the value and risk premium of the project varies through its life-cycle To derive the value and risk premium of the project, the model works backwards in a dynamic fashion Suppose that the firm completed the project and is ready to commercialize the product In the parlance o f the option literature, this is equivalent to exercising a growth option At this stage, the value of the project depends only on the cash flows to be generated from the project and the risk premium of the project simply equals the systematic risk of the underlying cash flows The intuition here is that after completion of the project no further investment decision is needed, and therefore the growth option has the same characteristics as the underlying cash flow This will not be the case, however, during the period of development of the project Prior to the

completion, the risk premium of the project is higher than that of the underlying asset

and increases as one moves back from the completion The intuition underlying this result is that a growth option represents a claim on future cash flows from the projects that a firm can realize by incurring additional fixed R&D expenditures Those future fixed payments represent the operating leverage, and the Black-Scholes model implies that this implicit leverage, which is reflected in option betas, should be priced This leverage makes the option riskier than the underlying asset The risk premium of the project, therefore, is directly related to the expected future payments or the strike price

of the option as well as to the value of the option For example, completion of a stage of the project reduces the future fixed payments and leads to an increase the value of the option The net result will be a decrease in the risk premium of the project

The option valuation of the project also takes into account an important element

of managerial flexibility: the option to suspend or “mothball” the project should the revised cash flow forecasts turn gloomy Because the innovative investment typically involves multiple stages, the manager makes investment decisions sequentially and can choose to suspend the project in unfavorable situations Therefore, the option to suspend the project is particularly valuable to the firm in early stages of the project and helps to reduce the overall risk of the project In general, as future cash flows increase, the value of the option to suspend decreases because it is less likely that the firm will suspend the project

To illustrate the potential magnitude of changes in the value and risk premium

o f the project over its life-cycle, Appendix A reproduces a table from the Berk et al paper They consider an R&D project that requires 20 phases to be completed The

table displays the value and risk premium of the project for three different levels of expected cash flows from the project at different stages of the project The first row gives the value of the project and the second row gives the risk premium of the project (annualized expected return minus risk-free rate) The numbers in parentheses show the value and risk of the project without the option to suspend or abandon the project As it

is evident from this table, holding the expected cash flows constant, the value of the project increases and its risk premium decreases as stages are completed In early stages

of the project, where real options represent substantial leverage, the risk premium is at least twice than that of the completed project The option to abandon, predictably, is more valuable in the early stages o f the project as the uncertainty and thus probability of abandoning the project is higher In addition, we can observe that risk premia are

generally higher for lower levels of cash flows, which usually corresponds to cases where it is optimal to suspend the project

Empirical Implications This simple real options model allows me to develop empirical predictions about how significant events in the life-cycle of an innovative project should affect both the systematic and idiosyncratic components of the equity risk Because asset pricing theory claims that investors require compensation for bearing systematic risk, changes in the systematic risk of a stock should lead to changes in its expected return in the same direction In addition, Merton (1987) argues that in the presence of market frictions and incomplete information, the idiosyncratic risk of a stock may be positively related to its

motivates my analysis of the systematic and idiosyncratic equity risk and stock return effects of innovative investment events with the purpose of providing a more complete understanding of the relation between stock returns and firm investment decisions However, before proceeding to the discussion of specific hypotheses it is worth mentioning that, as Berk et al point out, the complexity of the model precludes closed- form solution for the value and risk premium of the firm I chose to present Equations (1) and (2) in that form in order to provide important insights into the sources and magnitudes of the influence of growth options and thus facilitate hypothesis development My empirical tests therefore address only the relations suggested by Equations (1) and (2), rather than an exact functional form of the real options theory.

In the context of the biotechnology and pharmaceutical industries, the new innovative investment project starts when a firm obtains exclusive rights to the growth option, where the underlying asset is a stream of cash flows from a new drug An innovator firm can obtain exclusive rights to growth options in two ways: 1) obtaining a patent on its own discovery o f a new chemical or biological compound; or 2) acquiring technologies and know-how of existing firms The innovative investment project ends after the firm completes the research and development stages and files a new drug application with the FDA Completion of the project and the subsequent exercise of the growth option is equivalent to deciding to obtain FDA approval for the marketing of the drug

Figure 1 Timeline of Events and Predicted Changes in Risk and Returns

Growth option is discovered o r acquired A firm decides to develop the project based on the expected costs to completion and projected future cash flows

'’Announ R> 0_A_

T=0

20 months Change in E(R) >0 Change in Risk >0

T=1

A firm periodically decides w hether to continue investing in the project based on the revised estim ates o f the project variables.

Clinical trials I, II and III

N m onths

-Growth option is exercised if a firm decides

to bring the product to market based on the new cash flow projections.

/A nnoun R> 0 A

T=2

■ 20 m onths

Change in E(R) < 0 Change in Risk < 0

Prediction 1 All else equal, patent application and approval events increase the

systematic and idiosyncratic risk ofpatenting firms and their expected returns The

immediate stock market reaction to the announcement is positive.

As discussed below, patents provide biotech and pharmaceutical firms exclusive rights to growth opportunities by securing their claim to commercialize a new chemical

or biological entity Therefore, I argue that patents signal to the market that a firm has discovered a growth option, which will require additional investments before the value

of the underlying asset is realized Because a new growth option now accounts for a certain fraction of firm value, patenting firms will experience an increase in their cost of equity capital, which in turn leads to higher expected returns This prediction reflects an assumption that the asset underlying the option closely mimics assets-in-place and thus the growth option is riskier than the assets in place

I also expect a positive immediate reaction by the stock market to the patenting event Equation (1) shows that the price of a firm’s stock increases in the value of growth options Therefore, an announcement of a discovery of a new growth option should immediately raise stock prices

Prediction 2 All else equal, new drug applications reduce the systematic and

idiosyncratic risk o f firms and their expected returns The immediate stock market

reaction to the announcement is positive.

A new drug application is submitted to the FDA for review once the development phases have been completed and the firm believes it has sufficient

evidence for approval Marketing for the new drug can only begin after the FDA approves the drug The new drug applications therefore can be considered as a successful completion of the project and the exercise of the growth option Because exercising the growth option substitutes a riskier asset for relatively less risky assets in- place, the event will lower the firms’ cost of equity capital and, consequently, expected returns.

The announcement of a new drug application also raises the value of the project

to the firm because the potential cash flows are now more likely Therefore, the immediate stock market reaction to these announcements is expected to be positive

Prediction 3 All else equal, innovation-targeted acquisitions are associated

with an increase in the systematic and idiosyncratic risk o f acquiring firm s and their

expected returns The immediate stock market reaction to the announcement is positive.

Established pharmaceutical firms often purchase R&D firms in order to gain access to their technologies and knowledge base Therefore, the acquirer gains the value not only of the target firm’s assets in place but also of the option to develop and market the target firm’s potential research output If such acquisitions result in a significant expansion in the acquiring firms’ portfolio of growth options, I expect to observe a positive impact of innovation-targeted acquisitions on the cost of equity capital and expected returns of the acquiring firms This prediction again reflects an assumption that the asset underlying the growth option closely mimics assets in place and thus the

acquired growth option has higher risk premium and therefore expected return than the assets in place.

The immediate market reaction to these announcements is expected to be positive because an acquisition of a new growth option increases the overall firm value and thus should immediately raise stock prices

Prediction 4 Changes in the risk and returns o f an innovator firm 's equity

following the innovative investment event is positively related to the relative value o f the

growth option embedded in the investment.

Equations (1) and (2) show that the impact of the event on the firm’s risk and return is a function of the ratio of value of the growth option embedded in innovative investment to overall value of the firm Thus, relatively more valuable real options will have a greater effect on changes in the equity risk and returns of innovator firms

The implicit null hypothesis is that the new information about growth options is not systematically related to the risk and return of a firm’s equity This would hold, for example, if investors fail to take into account the full effect of the new information on the required return for a firm’s equity Because innovative investments, by their very nature, are characterized by high uncertainty, investors face a daunting task in assessing the proper expected return to compensate for changes in the systematic risk In addition, because the risk of failure and success of the project is largely idiosyncratic in nature, the argument can be made that the overall risk of innovative projects is a diversifiable risk which would not affect the required rate of return

The Effect of Competition and Business Cycle

It is important to note that investment activities of biotech and pharmaceutical firms are more complex than their depiction in the real options models A natural concern is that the model, while useful for illustrative purposes, is too restricted I discuss this issue by considering how product-market competition and the business cycle may affect empirical results

The real options models considered here link firm investment decisions and asset return dynamics in the absence of competitive pressures In the real world, however, the value of firms’ growth options embedded in investment projects are closely related to competitive interaction in an industry Investors arguably evaluate not only potential cash flows from innovations, but also the firm’s ability to successfully commercialize and protect their innovations from competitors Standard economic and finance theory predicts that more competition reduces the monopoly rents that reward successful innovators and thus the value of the firm’s growth options Schumpeter (1934) suggests that an innovative new product initially earns relatively high profits and attracts imitators, which increases the level of competition Increased competition erodes profits for innovator firms Schumpeter (1950) suggests, however, that firms with more market power are able to fend off the competition and thus can earn higher and more persistent returns from new products Grenadier (2002) shows that under perfect competition, the value of growth options is zero due to the possibility of preemption Garlappi (2004) also shows that competition among R&D ventures erodes

the option value to wait, increases the risk premia and uncertainty, and accelerates investment Sundaram, John and John (1996) find that individual firm’s strategic position in an industry has a significant impact on the firms' stock price response to the announcement of R&D spending They suggest that the R&D investments should be studied in the context of the industry structure, as well as individual firm’s position in the industry Aguerrevere (2006) introduces product market competition into a real options model and shows how competitive interactions among firms in a given industry affect the risk of growth options and asset in place He finds that in the more

competitive industries the value of growth options is lower because the firms exercise their growth options earlier to avoid losing the investment opportunity to its

competitors In addition, the risk of assets in place for firms in more competitive industries is higher because the firms have less ability to reduce capacity in economic downturns This implies that change in firms’ equity risk and returns upon either exercise or acquisition of the growth options is predicted to be lower for more competitive industries This discussion indicates the necessity to control for the intensity o f product market competition in my analysis

Zhang (2005) argues that the magnitude and the direction of the impact of growth options on the risk and expected returns might depend on the aggregate economic conditions Zhang argues that assets in place are riskier than growth options, especially in bad times Zhang’s argument relies on two features of his model, costly reversibility and countercyclical price of risk Costly reversibility means that it is costlier to disinvest physical assets than to install assets and countercyclical price of risk

means that the discount rate is higher in bad times such as economic downturns

Together, the time-varying price of risk and costly reversibility result in a higher risk premium of assets in place in bad times Thus, in contrast to Carlson et al (1999) and Gomes, Zhang and Kogan (2003), Zhang’s model implies that conversion of growth options into assets in place might actually increase the risk and expected returns This indicates the necessity to control for the business cycle in my analyses

Finally, it is important to state that the real options approach, as in Berk et al (1999,2004), is not the only economic analysis of this type of problem The key insight

of the real options models is to stress the functional equivalence between real investment decision and financial contracts This allows a study of the determinants of the risk premia and expected return o f the innovative investment project and the firm as

a whole, which is what I focus on Cornell (1999) presents another theoretical attempt to link firms’ decisions related to the development and exercise of growth options to changes in systematic risk of their equity The argument is that innovative projects, such

as R&D projects, are high-duration assets, i.e cash flows from these projects tend to come further in the future Cornell argues that this explains why the market betas of Amgen and other biotech and pharmaceutical companies are much too high to be explained by relatively low correlation between R&D projects’ cash flows and the market I believe that the Cornell’s paper represents an interesting alternative approach, however I do not examine its implication because it is not clear how to model and measure the duration of individual projects

stock valuation of innovative firms to time-varying uncertainty about their growth rates They argue that an increased uncertainty about the average future profitability raises the firm’s current stock price and idiosyncratic stock volatility Transposed to my setting, Pastor and Veronesi’s model implies that investment in new innovative projects, because o f high uncertainty about projects’ future profitability, is likely to increase the idiosyncratic volatility and current stock prices of investing firms Their model is, however, silent on the implications of innovative investments for the risk premium and expected returns of the investing firms.

CHAPTER IIITHE PHARMACEUTICAL AND BIOTECHNOLOGY INDUSTRIES

BackgroundWhile I believe the analysis in this paper is pertinent across a range ofinnovative industries, I focus on the pharmaceutical and biotech industries, as aparticularly propitious setting to examine the impact of real options on the equity riskand returns of firms These are dynamic and innovative industries driven by researchand development1 The biotech and pharmaceutical industries are of substantialeconomic importance, representing well over 10% of the U.S stock market

1 The pharmaceutical industry is one o f the m ost research-intensive industries in the U S., with an average research and developm ent (R& D ) to sales ratio o f 18%, compared to 4% for the U.S

manufacturing industry overall In 2004 the R&D expenditures for U S pharmaceutical com panies

totaled $38.8 billion (Pharmaceutical Research and Manufacturers o f America (P h R M A ), Industry

Profile 2005)

2At the end o f 2005 the total value o f publicly traded U S biotech com panies was $488 billion (Burrill & Company) and the total value o f publicly traded U S pharmaceutical com panies w as around $1 trillion (based on CRSP data).

between projects that would be impossible to obtain in a broad sample The metrics used to measure the value and risks of real options vary widely by industry The measurement of these variables across industries is likely to introduce substantial error.

By focusing on biotech and pharmaceutical firms as my empirical context, I follow a number of recent studies in finance that also examine the investment and financing decisions of pharmaceutical firms Lemeret al (2003) examine the role that the availability of equity financing has on the bargaining power of the research­

intensive firm and the subsequent allocation of property rights in biotech- pharmaceutical alliances Guedj (2005) and Guedj and Scharfstein (2004) study the effects of agency conflicts on the drug development strategies of pharmaceutical and biotechnology firms Higgins and Rodriguez (2006) and Danson, Epstein and Nicholson (2004) examine the determinants and announcement effects of pharmaceutical and biotech mergers and acquisitions However, none of these studies look at

pharmaceutical and biotech firms’ investment decisions in the real options framework

A natural question to consider is the extent to which the real options framework discussed in the previous section corresponds to the reality of biotech and

pharmaceutical firms R&D investments of pharmaceutical firms have often been characterized in the literature as investment in the creation of growth options (e.g Dixit and Pindyck, 1994; Berk, Green and Naik, 2004) Unlike in other industries, growth options of pharmaceutical and biotech firms are clearly demarked as they come in the form of new patents and drugs created after costly and lengthy investment in R&D

Therefore, a patent and a drug development project can be viewed as a compound option on the expected development costs and the estimated cash flows of the drug.

The drug discovery and development process is a rigorous and well-documented sequential process According to Henderson and Cockbum (1996), there are two stages

in pharmaceutical research and development: drug discovery and drug development.The goal of the drug discovery stage is to find a chemical or biological entity that has the desirable therapeutic effect, while the goal of the drug development process is to ensure that discovered entities are safe and effective in humans The process is shown in Figure 1 as well as in Figure 2, which also gives the success rate of drugs and the length

of time for each stage The development phase of an innovative drug begins when the pharmaceutical or biotech firm identifies a chemical or biological structure, sometimes referred to as molecular entity At that time, the pharmaceutical or biotech firm usually applies for a patent covering discovered chemical or biological entity If the firm wishes

to proceed with the development of the drug, it files for approval an investigational new drug application with the FDA to test the innovative drug on humans The human clinical tests occurs over three distinct phases, each of which contributes different amounts and types of information on safety and efficacy o f the drug candidate After completing the clinical trials, the company can seek regulatory approval by filing a new drug application or a biologic licensing application with the FDA A firm can market the new drug only after the FDA approval While the FDA is reviewing a drug application, the company attempts to develop the manufacturing and sales infrastructure necessary to market the drug Following approval, drugs enter the market directly