An Alternative Real Option Approach to R&D Project Assessment

Abstract

An organization can take diversifying actions to reduce the total risks of project portfolios. For an R&D project, the overall level of risk could be reduced with better management and/or appropriate diversifying. In this paper, we develop an alternative real option approach to assess R&D projects in consideration of diversifying investments. The distinguishing feature of our model setting is that two major uncertainties of R&D investment, i.e., the market and technological risks, are combined to generate a specific underlying process of R&D projects. The net present value rule and traditional real option methods are applied in evaluating R&D projects. It is found that the outcomes of the traditional real option methods would be affected by evaluators' expectation upon the market or technological outlook. The proposed method incorporating diversification effect could lead to more reasonable assessments for R&D projects since the influence of R&D firms' subjective views could be resolved. The value creation effect from diversifying actions has been examined through the numerical analyses. The results indicate that better management for R&D investment diversification will increase the project value.