Real Option versus Traditional Methods: R&D Project Selection

Abstract

Capital budgeting is one of the most important decisions faced by the financial manager. Prior studies spanning the past four decades show financial managers prefer methods such as internal rate of return or non-discounted payback models over net present value. Most financial managers prefer to use multiple tools to evaluate a project investment decisions. Research and Development (R&D) projects are characterised by high cost, high risk, and long lead time, interdependency and sequence of implementation. Further, these projects have various flexibilities available to the management such as option to delay, cancel, or undertake subsequent decision. The widely used DCF and other traditional methods fail to correctly assess the real value of these projects. In view of various limitations of conventional methods, Real Option Valuation (ROV), a more appropriate technique which incorporates impact of flexibilities, has been used for evaluation of projects. This methodology is based on the famous option pricing principles developed by Black and Scholes (1973).