Real R&D options1

Abstract

Real options have been growing in popularity in recent years, and this has been accompanied by improvements in their modelling and valuation. Real options enable companies or managers to value projects more accurately by incorporating managerial flexibilities into the valuation model. This is in contrast to traditional discounted cash flow valuation, where projects are assumed to proceed as planned, regardless of future events. One area where real option techniques have been used extensively is in R&D. This paper gives a review of the research on real R&D options, starting with the fundamentals, then detailing more innovative and up‐to‐date models as well as discussing the difficulties of applying these models, particularly with reference to parameter estimation. It also attempts to provide a ‘best practice’ for practitioners wishing to value R&D projects using real options.