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Valuation of R&D Investment Opportunities with the Threat of Competitors Entry in Real Option Analysis

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  • Giovanni Villani

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Abstract

This paper provides a real option methodology in order to value a pioneer’s R&D investment opportunity allowing for more potential competitors to enter in the market. To incorporate this competitive dimension, we assume that the pioneer may lose the “competitive dividends” if the real option is not exercised. According to Majd and pindyck ( 1987 ) (Journal of Financial Economics 18(1):7–27), in a real options context, “dividends” are the opportunity costs inherent in the decision to defer an investment project and so deferment implies the loss of project’s cash flows. Concerning this, Trigeorgis ( 1996 ) (Real Options: Managerial Flexibility and Strategy in Resource Allocation, The MIT Press, Cambridge, ( 1996 ) incorporates the preemption effect through the “competitive dividends” which are the cash flows that can be eroded by anticipated competitive arrivals. In particular way, we propose the valuation of a pioneer’s R&D investment assuming that the Development cost can be spent in two moments: $$t_2$$ or $$t_3$$ . If the Development cost is realized in $$t_2$$ no firms enters in the market since the rivals’ R&D plan is not yet concluded otherwise, if the Development cost is delayed until time $$t_3$$ waiting better market conditions, other rivals may enter in the market and so the opportunity costs, namely dividends, increase. Moreover, we analyze the optimal timing to realize the Development investment, i.e. we determine the conditions for which the pioneer prefers to invest the Development cost at time $$t_2$$ or $$t_3$$ . Copyright Springer Science+Business Media New York 2014

Suggested Citation

  • Giovanni Villani, 2014. "Valuation of R&D Investment Opportunities with the Threat of Competitors Entry in Real Option Analysis," Computational Economics, Springer;Society for Computational Economics, vol. 43(3), pages 331-355, March.
  • Handle: RePEc:kap:compec:v:43:y:2014:i:3:p:331-355
    DOI: 10.1007/s10614-013-9370-2
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    References listed on IDEAS

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    1. 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.
    2. Carr, Peter P, 1988. " The Valuation of Sequential Exchange Opportunities," Journal of Finance, American Finance Association, vol. 43(5), pages 1235-1256, December.
    3. Armada, Manuel Rocha & Kryzanowski, Lawrence & Pereira, Paulo Jorge, 2007. "A modified finite-lived American exchange option methodology applied to real options valuation," Global Finance Journal, Elsevier, vol. 17(3), pages 419-438, March.
    4. Flavia Cortelezzi & Giovanni Villani, 2009. "Valuation of R&D Sequential Exchange Options Using Monte Carlo Approach," Computational Economics, Springer;Society for Computational Economics, vol. 33(3), pages 209-236, April.
    5. Lambrecht, Bart & Perraudin, William, 2003. "Real options and preemption under incomplete information," Journal of Economic Dynamics and Control, Elsevier, vol. 27(4), pages 619-643, February.
    6. Thijssen, Jacco J.J., 2010. "Preemption in a real option game with a first mover advantage and player-specific uncertainty," Journal of Economic Theory, Elsevier, vol. 145(6), pages 2448-2462, November.
    7. Andrea Gamba, 2002. "Real options Valuation: A Monte Carol Approach," Working Papers wpn02-02, Warwick Business School, Finance Group.
    8. Drew Fudenberg & Jean Tirole, 1985. "Preemption and Rent Equalization in the Adoption of New Technology," Review of Economic Studies, Oxford University Press, vol. 52(3), pages 383-401.
    9. Robert McDonald & Daniel Siegel, 1986. "The Value of Waiting to Invest," The Quarterly Journal of Economics, Oxford University Press, vol. 101(4), pages 707-727.
    10. Grenadier, Steven R, 1996. " The Strategic Exercise of Options: Development Cascades and Overbuilding in Real Estate Markets," Journal of Finance, American Finance Association, vol. 51(5), pages 1653-1679, December.
    11. McDonald, Robert L & Siegel, Daniel R, 1985. "Investment and the Valuation of Firms When There Is an Option to Shut Down," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 26(2), pages 331-349, June.
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    More about this item

    Keywords

    Real options; R&D; Monte Carlo methods; Competitive dividends; G13; O32; C15; D40;

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • O32 - Economic Development, Innovation, Technological Change, and Growth - - Innovation; Research and Development; Technological Change; Intellectual Property Rights - - - Management of Technological Innovation and R&D
    • C15 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Statistical Simulation Methods: General
    • D40 - Microeconomics - - Market Structure, Pricing, and Design - - - General

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