Risk-Adjusted Valuation of R&D Projects

Abstract

OVERVIEW:The decision-free approach to the valuation of R&D projects is mathematically identical to a probability-adjusted sequence of real options, when systematic (or market) risk is set to zero. Besides adding confidence to the calculation, this observation allows a clean separation of the value contribution of the option to abandon contained in a stage gate approach plus the additional value gained from market risk (as measured by volatility). One consequence is to enable the risk-adjusted valuation of R&D projects on a compact and familiar set of variables: net present value, initial investment, and the estimated cost, duration and probability of success for each R&D stage. An estimate of the value of the project at the completion of each successive R&D stage is also a useful output of the method.

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