Capturing the Option Value of R&D

Abstract

OVERVIEW:Real option models capture the value of flexibility in R&D projects. This value lies in the fact that management always has the option to abandon the project if the results of R&D are not promising, thus limiting losses to the amount invested in the R&D phase. Traditional net present value (NPV) analysis fails to recognize this flexibility and therefore tends to undervalue R&D opportunities. The Black-Scholes model has been used extensively for financial options, but may be difficult to apply to R&D projects. Instead, it is suggested that the cost and revenue cash flows associated with implementing a project be used to measure the option value of R&D. This model captures the uncertainty associated with cash flow projections while simplifying some of the assumptions and data required for the Black-Scholes model.

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