Inderscience Publishers

Inderscience Publishers

An option model for R&D valuation

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Courtesy of Inderscience Publishers

The valuation of research and development is a difficult task for managers. The traditional net present value methods fail to consider the value of managerial flexibility provided by R&D projects the option to implement the results of the project if the research phase is successful, or terminate it if the results are not promising. The ability to abandon the effort allows management to limit losses and is similar to a stock option, which can be valued using well-established option pricing theory (Black-Scholes model). Unfortunately, many of the assumptions made for stock prices are not applicable to R&D projects, making it difficult to apply the Black-Scholes model to real options. In particular, changes in the value of the underlying asset resulting from R&D efforts are not entirely random and cannot be modelled as a random walk. The model presented in this paper addresses this problem by making no assumptions about how the underlying asset value changes over time. Instead, the R&D value is derived from the production and marketing costs and anticipated revenues of the project. This approach provides a simple tool that will appeal to practitioners familiar with cost and revenue projections.

Keywords: real options, R&, D valuation, R&, D management, R&, D investment

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