Valuation of R&D Investment Opportunities with the Threat of Competitors Entry in Real Option Analysis

Abstract

This paper provides a real option methodology in order to value a pioneer's R&D investment opportunity allowing for more potential competitors to enter in the market. To incorporate this competitive dimension, we assume that the pioneer may lose the "competitive dividends" if the real option is not exercised. According to Majd and pindyck (1987) (Journal of Financial Economics 18(1):7---27), in a real options context, "dividends" are the opportunity costs inherent in the decision to defer an investment project and so deferment implies the loss of project's cash flows. Concerning this, Trigeorgis (1996) (Real Options: Managerial Flexibility and Strategy in Resource Allocation, The MIT Press, Cambridge, (1996) incorporates the preemption effect through the "competitive dividends" which are the cash flows that can be eroded by anticipated competitive arrivals. In particular way, we propose the valuation of a pioneer's R&D investment assuming that the Development cost can be spent in two moments: $$t_2$$ or $$t_3$$ . If the Development cost is realized in $$t_2$$ no firms enters in the market since the rivals' R&D plan is not yet concluded otherwise, if the Development cost is delayed until time $$t_3$$ waiting better market conditions, other rivals may enter in the market and so the opportunity costs, namely dividends, increase. Moreover, we analyze the optimal timing to realize the Development investment, i.e. we determine the conditions for which the pioneer prefers to invest the Development cost at time $$t_2$$ or $$t_3$$ .