Improving the valuation of research and development : a composite of real options, decision analysis and benefit valuation frameworks

Abstract

The objective of research and development (R&D) is to create valuable complements to the existing capabilities of the firm. Unfortunately, valuing R&D is difficult because it is an uncertain and sequential process that often yields complex benefits such as simultaneous cost and performance improvements. These characteristics obscure important sources of value from common valuation methods such as net present value analysis (NPV). This thesis examines methodologies that have been singularly applied to evaluate R&D, and combines several into a composite framework as improved approach to valuing R&D. It focuses on valuing opportunities to revise R&D projects in response to uncertainty resolution, better matching valuation frameworks to project uncertainties, and integrating methods for valuing complex benefits with financial valuation frameworks. The composite methodology includes a financial valuation model that combines real options and decision analysis to resolve the difficulty of valuing option-like decision opportunities in R&D projects. This model is applicable across a range of project uncertainties. Multi-metric valuation methods and scenario analyses can transform complex benefits into dollar values that are compatible with the financial valuation model. A case study based on an automotive producer's investments in advanced materials R&D demonstrates the composite methodology. It also compares several valuation models including real options, decision analysis, NPV, and a weighted benefits index. the thesis demonstrates that R&D is significantly more valuable than comMon valuation methods suggest. In particular, it provides a legitimate basis for quantifying in dollars the appreciable strategic value of long-term, high-risk R&D efforts that frequently appear unattractive on an NPV basis. It also identifies conditions under which various methods for valuing projects are applicable, and highlights resolution and practicality trade-offs associated with these valuation frameworks.