Valuation of options in R&D.

Pizmoht, P. ; Polajnar, A. ; Palcic, I. 等

Abstract: In this article we apply an option approach to the R&D process and discus the issues that are of relevance for successful option valuation. We propose a model that combines qualitative and quantitative option valuation, which should improve the confidence of the results. The valuation should be precise enough to provide guidance for decision makers, and simple enough to be intuitive. In addition selected assumptions are discussed and some future research directions are suggested.

Key words: real options, R&D, project evaluation, flexibility

1. INTRODUCTION

Research and development (R&D) has become one of major determinants of a competitive position in high-technology industries. In these industries, due to rapid changes in technology and market, it has been very difficult for a firm to survive without proper evaluation of investment alternatives. In order to evaluate an R&D project correctly, it is essential to investigate its cash flows, which are often governed by technical and commercial uncertainty. In this article, we apply an option approach to the R&D process and discus the issues that are of relevance for successful option valuation. Our option approach builds upon the classic insight that R&D creates an option--contrary to a fixed obligation on market launch after R&D has been completed. Subsequently, management has a timing option to launch the new product any time after R&D has been completed, opposite to market introduction at a predetermined point in time.

2. CHARACTERISTICS OF R&D PROJECTS

An R&D project has unique features compared to a conventional project carried out routinely:

* uncertainty of the cost of the total investment and the return from completion,

* sunk cost of R&D investment,

* flexibility about the timing of the investment,

* subsequent investment decision.

Estimation of costs and payoffs can be challenging, and many investment errors have resulted from inaccurate estimation of benefits and costs. If a R&D project fails, the cost of R&D investments is usually irreversible, it is considered sunk. The firm always requires accurate information about future, and they might invest now if the future is favorable and postpone their decision otherwise. Such freedom on an investment decision is considered as investment flexibility. R&D investments provide a firm with the investment opportunity in the future to commercialize the project if market conditions are favorable at that time. The valuation of R&D investments can be considered as the valuation of its investment opportunity, which is analogous to a call option. The sequence nature of typical R&D projects provides decision makers with management flexibility as to whether to undertake opportunities at every stage. The decision of R&D investment at each stage is viewed as an opportunity to invest. The traditional DCF techniques fail to capture strategic concerns of an investment opportunity (Boer, 2003).

3. REAL OPTIONS

DCF (Discounted Cash Flow) based approaches assume that a project will be undertaken now and operated on continuously at a set time scale, until the end of its expected useful life, even if the future is uncertain. Therefore the DCF ignores the upside potential of added value that could be brought to the project through the flexibility and innovations of management to change the course of investment (Yeo & Qiu, 2003). Another weakness of DCF is its inability to determine the value that uncertainty adds to a project investment. Through the 1980s, financial option evaluation methods had been applied to evaluate flexibility associated with physical investments which has fundamentally changed the way people think about investment opportunities. So called real options are options on real assets, which can be defined simply as opportunities to respond to changing circumstances of a project by management. These opportunities to change are rights but not obligations to take some action in the future (Dixit & Pindyck, 1995).

3.1 Application of option analysis to R&D project valuation Faulkner (1996) points out that options thinking for the valuation on R&D investments brings valuable insights into the R&D valuation process. Suppose that an R&D project is characterized in a two-stage process, R&D stage and commercial stage, and that the investment costs are irreversible. The research in the initial stage, which is highly uncertain, can be thought of as attempts either to introduce a new technology or to extend an existing technology. Resolution of uncertainties can only be accomplished by either acquiring information from outside the firm or by in-house research. Therefore, initial research is itself an optional decision. Possession of an option is referred to as a right to obtain potential further research outputs by paying R&D investment costs when we focus on the in-house R&D. A subsequent decision, a commercialization investment, heavily depends upon consequences of R&D. Investors can also have the flexibility to delay or stop the commercialization investment. Thus, the decision is also considered as an option choice. Luehrman (1998) argues that when one decides on the amount to spend on R&D or the kind of R&D to pursue, one is really valuing opportunities. He explains that opportunities are different from assets-in-place because a decision-maker acts after resolving uncertainty rather than after making a decision and then finding out what happens. He concludes that the options approach rather than traditional DCF methods is better suited to value opportunities.

As the sequence nature of an R&D project is displayed by options, R&D investments can be compared to a call option involving a future commercialization decision to exercise the option to invest only when the R&D is successful. There are some similarities between R&D investments and a call option on a common stock. As a call option gives its holder the right to exercise common stocks, a call option in R&D investments provides a firm with business opportunities resulting from R&D on the predetermined date (a European call option). If the outcome looks promising, it will be exercised by making an additional investment for the next period. If it does not look promising, the firm will allow the R&D option to expire and the loss will be limited to the amount in the initial R&D investment.

Based on the analogy of a call option, the investment cost to commercialize an R&D project can be considered as the exercise price and the present value of the future cash inflow from the commercialization as the underlying asset value. Valuation of the completed R&D is difficult. However, a firm could get an approximation on this value through the secondary market from patent and license agreements. The market value for patents and licensing agreements as the value of an R&D project can be calculated comparing to R&D cost, final manufacture cost, and sales of other similar past projects. The date at which the new product is introduced into the market can be considered as the expiration date.

3.2 Valuation of real life R&D projects

For real options analysis most of the modeling inputs are estimates. Therefore, the decision-maker needs to be aware that the real option value calculated is a guesstimate of the "true" option value. Instead of modifying financial option to fit real options, future modeling efforts should concentrate on developing practical methods for improved decision-making. Mathematical "accuracy and complexity" should be replaced with viable real option models that will be supported by practitioners (Miller & Park, 2002). Neufville (2003) states that getting exact input values for real options is unnecessary because real option analysis should support making a choice. We only need to know the relative value of alternatives, not their precise value. And that are the statements we have also considered in our option valuation model.

In our research we identified following factors that affect the option value in R&D projects:

* potential revenue stream,

* adaptation speed,

* factors that prevent market entry,

* competitive response,

* ease of technology imitation,

* standard set-up potential,

* commercialization cost,

* development cost.

To appropriately valuate the embedded options firms should firstly perform a qualitative valuation. They should develop branch specific questionnaire that will address the above mentioned factors. The results can then be compared with similar past R&D projects to gain logical conclusions.

There is an enormous desire on the part of managers to quantify this values. But we think that this temptation should be avoided. The investment value greatly depends on the configuration of competences and resources already belonging to a firm, so the value is a function of the capabilities of the specific firm making the investment. This does not mean that quantitative option valuation should not be performed. We should try to calculate the R&D option value with the help of known real options models and techniques, but separated.

The reason for inclusion of qualitative option valuation is to avoid a black box which top management will not trust. If real option valuation were simply the process of producing a number, more companies would have adopted real options. Without alignment of the valuation framework and how managers think they are going to run their project, the valuation result lacks credibility. The real options calculations most often fail at a basic level, because everyone is way too confused to want to understand the calculation detail. The success depends on getting the big picture right. The question is who is going to use the results, why is going to use it and how should the results compare to the value of other assets. To quantitatively value R&D real options some assumptions are inevitable. When too many assumptions are made, the model becomes too simplistic. However, reducing the assumptions increases the complexity of an option model. In our research following assumptions were made in addition to the basic assumption that the market is perfect:

* uncertain variables are uncorrelated with each other,

* a variance of each variable is predictable,

* the level of investment per period is constant.

Since real R&D investment opportunities are often complex or reasonably sophisticated due to a number of uncertain variables, our first assumption is not realistic and the second assumption may be relaxed. Thus a powerful capital budgeting model to allow for various uncertain variables having interrelations with each other is required. In addition, if an R&D project requires a variable level of investment, our third assumption is also unrealistic. In this case, our object function must be modified to allow for the variable rate of investment. This is an ongoing research, so there are few open issues that should be solved.

Options research is a developing area. Some potential future research studies should include development of new valuation methodologies and applications that would better fit into real business environment and incorporate additional uncertainties. Interesting is also the possibility to valuate the option to invest when multiple projects are interrelated with each other, and innovative incorporation of technical uncertainty into the quantitative valuation models.

4. CONCLUSION

Real options reasoning is a logic for funding those projects that maximize upside opportunities while limiting downside risk. Although it has considerable advantages over conventional approaches, there are barely any applications available. In this article we have proposed an option valuation approach to R&D projects. It integrates both technological and market considerations. It is important to intensify research to reach a new level of valuation methodologies and applications that will be both precise enough to provide guidance for managers, and simple enough to be intuitive.

5. REFERENCES

Boer, F. P. (2003). Risk-adjusted valuation of R&D projects. Research Technology Management, Vol. 46, No. 5, pp. 50-58

Dixit, A. & Pindyck, R.S. (1995). The options approach to capital investment. Harvard Business Review, Vol. 73, No. 5-6, pp. 105-115

Faulkner, T. (1996). Applying Options Thinking to R&D Valuation. Research Technology Management, Vol. 39, No. 3, pp. 50-56

Luehrman, T.A. (1998). Investment opportunities as real options: getting started on the numbers. Harvard Business Review, Vol. 76, No. 7-8, pp. 51-60

Miller, L.T. & Park, C.S. (2002). Decision Making Under Uncertainty--Real Options to the Rescue?, The Engineering Economist, Vol. 47, No. 2, pp. 105-149

Neufville, R. (2003). Real Options: Dealing with Uncertainty in Systems Planning and Design, Integrated Assessment Journal, Vol. 4, No. 1, pp. 26-34

Yeo, K.T. & Qiu, F. (2003). The value of management flexibility--a real option approach to investment evaluation. International Journal of Project Management, Vol. 21, No. 5, pp. 243-250