29 June 2009

Pharmaceuticals and Capital Budgeting - A Review

Skrepnek, Grant H. and Sarnowski, Jeff J. Decision-making Associated With Drug Candidates in the Biotechnology Research and Development (R&D) Pipeline. Journal of Commercial Biotechnologys, 13,99-110.


The pharmaceutical / biotechnology industry is typically viewed as being as being a high risk venture. This is especially true when it comes to Research and Development (R&D) as a vast majority of projects never make it to market, and those that do average $800M in development costs. Thus, the importance of accurately assessing risk components of capital budgeting efforts is paramount. The present study, through survey with 7.5% response rate, explores various methodologies utilized in the industry. Findings show a penchant towards DCF methodologies such as NPV and IRR. However, DCF methodologies are usually combined with decision trees/decision analysis, sensitivity analysis, pharmacoeconomics, and real options methodologies. The role of past experience/intuition/judgment is still prevalent in the industry as well with 85% of respondents indicating a high reliance on the “soft” side of decision making; a surprising result given the advancement of other methodologies (specifically, DCF methodologies) in other industries.

The pharmaceutical / biotechnology industry is typically viewed as being as being a high risk venture. This is especially true when it comes to Research and Development (R&D) as a vast majority of projects never make it to market. Those that do make it to market average (according to the authors) $800 million in capitalized money to bring to market. Thus, it is a huge investment and a huge risk.

Historically, pharmaceutical / biotechnology companies have helped reduce the risk of empty development pipelines by entertaining and actively working on many projects in hope the lucky handful will come to fruition. With the advent of computer aided design of active compounds, the practice of filling the pipeline with many projects has begun to subside. And, with the cost of clinical trials, regulatory approval, and R&D costs in general increasing exponentially, any tool or technique that helps reduce the risk of having projects go bust is worthy of consideration in this industry.

In addition to using technology to increase the pipeline of promising products, some companies reduce the risk of busts by decreasing R&D efforts and acquiring promising technology from other companies in the business. Of course, this strategy commands a premium price since the developing firm has borne the bolus of risk seen at the beginning and middle stages of development and clinical trial.

With all this risk, the capital budgeting efforts are of utmost importance. The present study explored, among other things, the methodologies common to the industry in dealing with capital decision making. The methodology utilized was a survey, for which, a 7.5% response rate was observed (which is consistent with studies of this type).

The results of the study showed a wide array of techniques used but also showed some themes. Unlike a similar study in the 1960s, Discounted Cash Flow (DCF) methodologies were found to be the most utilized methods. Net Present Value (NPV) and Internal Rate of Return (IRR) were utilized by 74% of the respondents. However, it was noted, as other studies have also shown, these methodologies are less than ideal in cases where risk is high and difficult to accurately assess. These cases are certainly present in the pharmaceutical / biotechnology fields, thus, few firms were found to solely rely on DCF methodologies. Additional questions concerning DCF methodologies showed that only 11% of respondents found DCF methods valuable at the pre-clincal stage of development, and only 46% found them valuable at the clinical stage. This is further indication of the sketchy reliability of such methods in this particular industry.

With so few respondents finding DCF methodologies effective and valuable, one would expect the usage of such methodologies to be combined with alternatives. In fact, the study did find this to be true. Respondents (59%) also indicated they utilize decision trees/decision analysis methodologies to aid in capital budgeting. Respondents also indicated they utilize sensitivity analysis during budgeting cycles (54%). 28% all indicated they utilize real options. These findings show a high degree of reliance on multiple methodologies in the pharmaceutical / biotechnology field.

A surprising finding was that 85% of respondents indicated an ultimate, heavy reliance on past experience / intuition / human judgment (unlike certain other industries that rely solely on more sterile mathematical models). However, when one considers the level of risk and enormous uncertainty in R&D efforts in this industry, it really shouldn’t be a surprise that data is gathered using multiple models and then run through the filter of history/intuition/judgment and common sense.

The future of this industry is in great peril at the present moment, making capital budgeting efforts all the more important. With the general public hearing/seeing report after report about the billion dollar babies (drugs with sales over $1 billion annually), and virtually nothing on the billions spent fruitlessly in development work each year, pressure is on the firms from all sides to do their part to stem the tide of increasing medical costs. The present, poor excuse for an administration is, in my opinion, seeking entirely too many concessions from the industry as part of their plan to overhaul the American health care system. At some point, firms will not find it profitable to be saddled with all of the risk for a government-mandated reduced reward and will discontinue seeking ways to find treatments for certain conditions. There is already a huge problem in the industry in that lesser known conditions receive little to no attention because of the small population of patients, yet the development costs and risk of failure are unaffected regardless of population size. Every disincentive the current, idiotic administration and other uninformed citizens erect as a roadblock will further serve to prevent new therapies from being developed. Don’t get me wrong, the industry has plenty of problems of its own making and greed, but obstructing capitalism in this instance is not a good idea in my opinion. However, any improvements concerning the accuracy of capital budget cycles (specifically DCF methodologies) could go a long way to meeting goals of the company, the public, and governments across the globe, but the key to these developments is increased ability to quantify the risks associated with development.