We develop and analyze a model of a multi-stage investment project that captures many features of R&D ventures and start-up companies. An important feature these problems share is that the firm learns about the potential profitability of the project throughout its life, but that research and development effort itself is only resolved through additional investment by the firm. In addition, the risks associated with the ultimate cash flows the firm realizes on completion of the project have a systematic component, while the purely technical risks are idiosyncratic. Our model captures these different sources of risk, and allows us to study their interaction in determining the risk premia earned by the venture during development. Our results show that the systematic risk, and the required risk premium, of the venture are highest early in its life, and decrease as it approaches completion, despite the idiosyncratic nature of the technical risk.
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number
6745.
Length: Date of creation: Oct 1998 Date of revision: Handle: RePEc:nbr:nberwo:6745
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Find related papers by JEL classification: G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Investment Policy G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
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