Application of Real Options Analysis for R&D Project Valuation in High-Tech Public Corporation - Advanced Research on Computer Education, Simulation and Modeling - page 105

Application of Real Options Analysis for R&D Project
Valuation in High-Tech Public Corporation
Kai Zhang
Institute of Policy and Management, Chinese Academy of Sciences
Beijing, 100084, Ph.: (86) 10-68718932
[e-mail]
Abstract. This paper addresses the theme of real options decision-making in
R&D projects of High-Tech Public Corporation considering the characteristics
of R&D projects (including high-risk, multi-stage, expandability, product life
circle, etc.).The paper expanse traditional discounted Cash flow Analysis to the
uncertain process, and presents the Black-Scholes formula for evaluating of the
uncertainty. A solution algorithm which transforms the Black-Scholes equation
into constant coefficient diffusion equation is developed. The expanded
discounted Cash flow Analysis under uncertainty achieves investment decision-
making optimality that is generally not well presented in traditional approaches
for R&D projects.
Keywords: R&D, real option, Discounted Cash flow, Black-Scholes formula.
1 Introduction
Research and development (R&D) is vital to the development of enterprises, but How
to evaluate R&D projects has been a difficult problem. Traditional discounted Cash
flow (DCF) method, not considering the value of flexibility in decision-making, is
unfit for the valuation of R&D projects with great uncertainty. Considering some
characteristics of R&D projects (including high-risk, multi-stage, expandability,
product life circle, etc.), real option theory is employed to build the model of
valuation of the decisions.
Myers (1984) recognized the analogy between financial options and real world
investments. For this relationship, he coined the expression real option. This term
describes the cognition that, based on the resemblance mentioned above (R&D)
investments can be valued similar to financial options. The scientific basis for this
task is provided by the research of Black-Scholes and Merton who was awarded the
Nobel Prize in1997.Real options account for management flexibility which delivers a
significant value contribution in the presence of uncertainty. Therefore, real options
analysis (ROA) was recommended several times to be more adequate than traditional
discounted Cash flow (DCF) for judging R&D projects. In addition, following a real
option's perspective on R&D projects in R&D intensive companies has a positive
impact on both their R&D performance and their financial performance.