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Project Management Under Risk: Using the Real Options Approach to Evaluate Flexibility in R...D

Listed author(s):
  • Arnd Huchzermeier

    ()

    (WHU-Otto Beisheim Hochschule, Burgplatz, 56179 Vallendar, Germany)

  • Christoph H. Loch

    ()

    (INSEAD, Boulevard de Constance, 77305 Fountainbleau, France)

Registered author(s):

    Managerial flexibility has value in the context of uncertain R...D projects, as management can repeatedly gather information about uncertain project and market characteristics and, based on this information, change its course of action. This value is now well accepted and referred to as "real option value." We introduce, in addition to the familiar real option of abandonment, the option of corrective action that management can take during the project. The intuition from options pricing theory is that higher uncertainty in project payoffs increases the real option value of managerial decision flexibility. However, R...D managers face uncertainty not only in payoffs, but also from many other sources. We identify five example types of R...D uncertainty, in market payoffs, project budgets, product performance, market requirements, and project schedules. How do they influence the value from managerial flexibility? We find that if uncertainty is resolved or costs/revenues occur after all decisions have been made, more variability may "smear out" contingencies and thus reduce the value of flexibility. In addition, variability may reduce the probability of flexibility ever being exercised, which also reduces its value. This result runs counter to established option pricing theory intuition and contributes to a better risk management in R...D projects. Our model builds intuition for R...D managers as to when it is and when it is not worthwhile to delay commitments---for example, by postponing a design freeze, thus maintaining flexibility in R...D projects.

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    File URL: http://dx.doi.org/10.1287/mnsc.47.1.85.10661
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    Article provided by INFORMS in its journal Management Science.

    Volume (Year): 47 (2001)
    Issue (Month): 1 (January)
    Pages: 85-101

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    Handle: RePEc:inm:ormnsc:v:47:y:2001:i:1:p:85-101
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    1. Roberts, Kevin & Weitzman, Martin L, 1981. "Funding Criteria for Research, Development, and Exploration Projects," Econometrica, Econometric Society, vol. 49(5), pages 1261-1288, September.
    2. Merton, Robert C, 1998. "Applications of Option-Pricing Theory: Twenty-Five Years Later," American Economic Review, American Economic Association, vol. 88(3), pages 323-349, June.
    3. Elizabeth Olmsted Teisberg, 1994. "An Option Valuation Analysis of Investment Choices by a Regulated Firm," Management Science, INFORMS, vol. 40(4), pages 535-548, April.
    4. Majd, Saman & Pindyck, Robert S., 1987. "Time to build, option value, and investment decisions," Journal of Financial Economics, Elsevier, vol. 18(1), pages 7-27, March.
    5. James E. Smith & Robert F. Nau, 1995. "Valuing Risky Projects: Option Pricing Theory and Decision Analysis," Management Science, INFORMS, vol. 41(5), pages 795-816, May.
    6. Rothschild, Michael & Stiglitz, Joseph E., 1970. "Increasing risk: I. A definition," Journal of Economic Theory, Elsevier, vol. 2(3), pages 225-243, September.
    7. Thomke, Stefan H., 1998. "Simulation, learning and R&D performance: Evidence from automotive development," Research Policy, Elsevier, vol. 27(1), pages 55-74, May.
    8. Pennings, Enrico & Lint, Onno, 1997. "The option value of advanced R & D," European Journal of Operational Research, Elsevier, vol. 103(1), pages 83-94, November.
    9. Shantanu Bhattacharya & V. Krishnan & Vijay Mahajan, 1998. "Managing New Product Definition in Highly Dynamic Environments," Management Science, INFORMS, vol. 44(11-Part-2), pages 50-64, November.
    10. William C. Jordan & Stephen C. Graves, 1995. "Principles on the Benefits of Manufacturing Process Flexibility," Management Science, INFORMS, vol. 41(4), pages 577-594, April.
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