Evaluating Competing R&D Investments

Abstract

Since R&D projects typically last for a number of years, their quantitative analysis and comparison requires some rational means of adjusting project worth as a function of the time profile of project expenditures and returns. An additional adjustment must be made to account for the risk that is present in virtually all R&D activities. Since many projects last for as long as 10 years, these time and risk adjustments may be quite substantial, and may dominate the decision calculus. This paper examines the state of the art in such decision-making models, and recommends methods for improvement. We deal first with adjustments for time alone, ignoring risk. Later, we examine methods for adjusting for both time and risk. Adjusting for Time Alone The most common method of adjusting for time profiles of returns on capital investment projects is the present value technique (here we subsume both net present value and internal rate of return under the same heading). A 1978 survey suggested that more than 85 percent of firms use such techniques to make capital budgeting decisions (1). In another study, Rizzuto and Cook show that rate of return is the primary determinant in management choices abo'ut R&D spending levels However, a third, experimental, study shows that the manager's discounted cash flow is not always consistent with the classical present value approach (3). While present value techniques are sound and well-seasoned methods, they do require several restrictive assumptions about the decision maker's time preferences. These assumptions, which are usually unexamined, limit the applicability of the technique. The choice among cash flows with different time profiles is a multi-attribute decision theory problem of a special type. In choices of cash flows over time, the decision maker would like to maximize the cash flow in each year. Since it is rare that any choice will yield this utopian solution, the practicing manager must trade off one year's cash flow against another's. A decision theorist would model this tradeoff process with a multi-attribute value function. This may be very difficult in practice. Decision theory, however, allows us to describe the behavioral properties implied by different tradeoff techniques. The present value technique is a well-known and trusted method for accomplishing tradeoffs among cash flows. The decision maker who uses this technique, however, is assumed to possess the following preference characteristics: 1. Suppose the decision maker is to choose between two cash flow streams, x = (x1, x2, . . ., xn), and y = (y1, y2, . . ., yn). It is assumed that the present-value decision maker will prefer cash flow stream x to y if one year's cash flow in x exceeds the same year's flow in y while all the other years are equal. This assumption, called dominance, seems natural for virtually any rational decision maker. 2. Suppose that the decision maker is faced with two specific cash flow streams, x = (10,16,20,25,50,100), and y = (10,15,20,40,50,100). Notice that these two streams differ only in Years 2 and 4. Now further suppose that the decision maker preferred x to y due to the slightly higher return in Year 2 which would help in some temporary cash flow problem. If the decision maker is to satisfy the assumptions of present value, then the choice between x and y must not change if any of the cash flows (other than Years 2 and 4) are changed by an equal amount in both x and y. So assume that x = (100,16,20,25,50,100), and y = (100,15,20,30,50,100). With such high returns in Year 1, the short term cash flow problem in Year 2 is no longer a matter for concern, so the decision maker decides to choose y. This change in preferences is inconsistent with the assumptions about the present-value decision maker. 3. It is assumed that the present-value decision maker is indifferent between one dollar of cash flow in year t and 1 + r dollars in year t + 1, where r is the relevant discount rate. …