Valuation of R&D and Advertising Expenditures

Abstract

The purpose of the paper is to understand the role that uncertainty plays in determining the effect of R&D and advertising expenditures on market values. Real option literatures indicate that the investment on R&D or advertising can be viewed as purchase of growth options for firms. The cost of the investment is interpreted as the premium of the option. The growth option will be exercised only under favorable market outcome and thus has non-linear payoffs. Because of the convexity of the growth option, the value of the option increases with uncertainty in the market that a firm faces. In other words, the capitalization of R&D and advertising expenditures will be larger if there is higher uncertainty in the product market.The role uncertainty plays in determining the valuation of R&D and advertising expenditures is explored using different sets of sample through regression analysis and robust OLS estimation. Empirical evidences indicate that firms facing more uncertainty in the market tend to invest more in R&D projects but not in advertising expenditure. Managers realize growth option features of R&D projects and make more investments to capture the benefit of uncertainty for the value of R&D projects. The option analogy for R&D investment may well explain high P/E ratios for high-tech or start-up firms, which have large R&D investments and face higher uncertainty. On the other hand, it seems that uncertainty does not play an important role in determining the effect of advertising expenditure on market value, which means that investors may not view advertising investments as a growth options. Finally, findings in event study indicate that the abnormal returns over the announcements of new R&D projects increase when there is larger uncertainty in the market. This again confirms the conjecture that R&D investment is considered as purchase of a growth option and therefore the value of the investment is positive correlated to volatility.