ECONOMIC ANALYSIS OF R&D PROJECTS: AN OPTIONS APPROACH

Abstract

ABSTRACT An emerging trend in research and development (R&D) project valuation is the use of options approach, which permits a more flexible assessment of the future growth opportunities in the entire process. The traditional DCF method when naively applied fails to capture all the future opportunities that create value, thereby resulting in an under investment in R&D. The options approach is more appropriate in a world of uncertainty because it views an R&D project as an initial investment that creates future follow-on commercial opportunities that are undertaken only if the initial R&D project is successful. Valuation of R&D projects is usually complex due to substantial uncertainties at different project phases, including the R&D phase and commercialization phases. Several recent papers on real options indicate that valuations of R&D projects based upon an options approach have been neglected by the finance community. To help correct this deficiency, we develop a valuation model that incorporates the risk-free arbitrage features of the binomial option pricing model into a decision tree framework. We apply the model to Gillette's new MACH3 project to illustrate how one can use the options approach rather than the conventional DCF method to value an R&D investment involving the introduction of a new product. In addition, we demonstrate how valuation can be linked to a company's stock price to make more-meaningful economic decisions in the real world. Our approach enhances traditional economic analysis methods and thinking by linking capital budgeting decisions and stock prices within an options framework. The purpose is to demonstrate value of future opportunities for companies that strive to maintain stock price growth. In doing so, we challenge the typical engineering economic analysis that views engineering projects in isolation, thereby creating a big gap between theory and practice.