June 20, 2010
June 20, 2010
June 23, 2010
15.607.1 - 15.607.11
Funding Decisions for Multi-Stage Projects Abstract Large industrial projects are generally organized and funded in stages, with each stage funded and executed sequentially. This is widely practiced with new product and new technology development projects, venture capital projects, and natural resource development projects. It is required and regulated for pharmaceutical projects. Continued funding of a project generally requires the successful completion of a stage.
The methods used to value multi-stage projects are derived from the fields of finance and engineering economics. Traditional valuation techniques for multi-stage projects are based on decision trees; this is the primary method taught to engineering students. Proponents of real options have suggested that options analysis more closely follows the assumptions used in actually funding a project, but these new methods have other, unresolved problems.
Introduction Firms often undertake large investments in stages1. Rather than invest all required funds at the beginning of a large project, many firms will make a series of sequential investments based on the success of previous investments. Many projects involve multiple stages, and multi-stage economic analysis is often necessary. An example of a multi-stage project is pharmaceutical drug development, where new drug products must pass a series of clinical trials, and where successive clinical trials are performed (or not) depending on the success of the previous clinical tests. That is, Phase II tests are only performed if Phase I tests are successful, and Phase III testing is conducted only if Phase II is successful. Staged funding also occurs in many other large projects, where new ideas pass from concept development to product design and development to engineering, creation of manufacturing capacity, and product introduction into the marketplace. Each stage involves rapidly increasing monetary commitments, and each stage is funded only if the previous stage is successful — and not necessarily even then. For example changing markets, new drugs from competitors, and more promising drugs may stop a drug after a successful clinical trial. This paper is an initial analysis of stage-gate funding and it assumes that a successful clinical trial implies continuing with development. Staged funding is a method of managing the investment risk. While at each passed stage the probability of the drug reaching the market increases, the increasing financial stakes imply increasing amounts of risk.
Current methods for determining the value of staged projects use NPV analysis based on expected costs, expected revenues, and the probabilities of passing from one stage to the next. Decision trees are often used to organize the information and to calculate project value. Real options analysis can use compound options to determine an expanded net present value (ENPV) of a staged project. In high risk, high payoff projects, such as drug development, where the probabilities of moving forward are fairly low, options analysis may provide a different, and possibly more positive, project assessment. There is a possibility that options analysis will provide a more accurate project valuation than traditional methods if existing problems and concerns that exist with real options can be overcome.
In this paper, we examine the issue of staged funding. Engineering economics, finance, and project management textbooks are first reviewed to determine the extent to which we are
Lewis, N., & Eschenbach, T., & Hartman, J. (2010, June), Funding Decisions For Multi Stage Projects Paper presented at 2010 Annual Conference & Exposition, Louisville, Kentucky. https://peer.asee.org/15803
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