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R&D as an option on market introduction

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Abstract:

Discounted cash flow methods for making R&D investment decisions cannot properly capture the option value in R&D. Since market and technology uncertainties change expectations about the viability of many new products, the value of projects is frequently adjusted during the R&D stages. Capturing the adjustment in expectations has an option value that may significantly differ from the Net Present Value of R&D projects. However, there are no historic time series for estimating the uncertainty of the value of R&D projects. As a result, the standard Black and Scholes model for financial option valuation needs to be adjusted. The aim of this paper is to report the application of a particular option pricing model for setting the budget of R&D projects. The option value of the model captures jumps or business shifts in market or technology conditions. The approach originates from applying current insight into the valuation of R&D projects to the field of multimedia research at Philips Corporate Research. This way, the gap between real option theory and R&D practice is further diminished.

Document Type: Research Article

DOI: http://dx.doi.org/10.1111/1467-9310.00104

Affiliations: Department of Industrial Economics, H17–25, Erasmus University Rotterdam, P.O. Box 1738, 3000 DR Rotterdam, the Netherlands Lint@FEW.EUR.NL

Publication date: October 1, 1998

bpl/radm/1998/00000028/00000004/art00006
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