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Valuation of sequential R&D investment under technological, market, and rival preemption uncertainty

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  • Michi Nishihara

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    (Graduate School of Economics, Osaka University)

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    Abstract

    We develop a real options model for evaluating and optimizing an R&D project. The model can capture key features of R&D, including research duration, growth opportunity, debt financing, and uncertainty of technological, demand market, and rival preemption. Nevertheless, it is computationally tractable and thus helps practitioners to evaluate various cases of R&D investment. Further, by analyzing the model with a wide range of parameter values, we unveil the interactions of key R&D features. The effect of duration on investment depends on whether there is a possibility of rival preemption. Higher uncertainty of research duration speeds up project inception in the presence of rival preemption. Higher uncertainty of technological success, combined with a growth opportunity embedded in the R&D project, accelerates investment. Debt financing can greatly decrease time lag between the first stage project and growth project. These results are consistent with the empirical evidence.

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    File URL: http://www2.econ.osaka-u.ac.jp/library/global/dp/1413.pdf
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    Bibliographic Info

    Paper provided by Osaka University, Graduate School of Economics and Osaka School of International Public Policy (OSIPP) in its series Discussion Papers in Economics and Business with number 14-13.

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    Length: 28 pages
    Date of creation: Apr 2014
    Date of revision:
    Handle: RePEc:osk:wpaper:1413

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    Web page: http://www.econ.osaka-u.ac.jp/
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    Related research

    Keywords: R&D; technological uncertainty; investment lag; real options; compound option.;

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    1. Helen Weeds, 2002. "Strategic Delay in a Real Options Model of R&D Competition," Review of Economic Studies, Oxford University Press, vol. 69(3), pages 729-747.
    2. Goldstein, Robert & Ju, Nengjiu & Leland, Hayne, 2001. "An EBIT-Based Model of Dynamic Capital Structure," The Journal of Business, University of Chicago Press, vol. 74(4), pages 483-512, October.
    3. Hartmann, Marcus & Hassan, Ali, 2006. "Application of real options analysis for pharmaceutical R&D project valuation--Empirical results from a survey," Research Policy, Elsevier, vol. 35(3), pages 343-354, April.
    4. Fan, Hua & Sundaresan, Suresh M, 2000. "Debt Valuation, Renegotiation, and Optimal Dividend Policy," Review of Financial Studies, Society for Financial Studies, vol. 13(4), pages 1057-99.
    5. Christopher A. Hennessy, 2004. "Tobin's "Q", Debt Overhang, and Investment," Journal of Finance, American Finance Association, vol. 59(4), pages 1717-1742, 08.
    6. Bar-Ilan, Avner & Strange, William C, 1996. "Investment Lags," American Economic Review, American Economic Association, vol. 86(3), pages 610-22, June.
    7. Bar-Ilan, Avner & Strange, William C., 1998. "A model of sequential investment," Journal of Economic Dynamics and Control, Elsevier, vol. 22(3), pages 437-463, March.
    8. Cassimon, D. & De Backer, M. & Engelen, P.J. & Van Wouwe, M. & Yordanov, V., 2011. "Incorporating technical risk in compound real option models to value a pharmaceutical R&D licensing opportunity," Research Policy, Elsevier, vol. 40(9), pages 1200-1216.
    9. Suresh Sundaresan & Neng Wang, 2007. "Investment under Uncertainty with Strategic Debt Service," American Economic Review, American Economic Association, vol. 97(2), pages 256-261, May.
    10. Ariel Pakes & Mark Schankerman, 1984. "The Rate of Obsolescence of Patents, Research Gestation Lags, and the Private Rate of Return to Research Resources," NBER Chapters, in: R & D, Patents, and Productivity, pages 73-88 National Bureau of Economic Research, Inc.
    11. Guthrie, Graeme, 2009. "Real Options in Theory and Practice," OUP Catalogue, Oxford University Press, number 9780195380637, September.
    12. Driver, Ciaran & Temple, Paul & Urga, Giovanni, 2008. "Real options -- delay vs. pre-emption: Do industrial characteristics matter?," International Journal of Industrial Organization, Elsevier, vol. 26(2), pages 532-545, March.
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