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Real R&D options and optimal activation of two-dimensional random controls

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  • S H Martzoukos

    () (University of Cyprus)

Abstract

Abstract We value investments under uncertainty with embedded optional costly controls (impulse-type with uncertain outcome) that capture managerial intervention for value enhancement and/or information acquisition (exploration, R&D, advertising, marketing research, etc). Implementing real option models but neglecting such embedded managerial actions can severely underestimate investment opportunities and lead to erroneous investment decisions. Optimal decisions are solutions to a maximization problem where the trade-off between the control's cost and the value added by such actions is explicitly taken into consideration. In this paper, we generalize such a methodology from one dealing with the special case of actions affecting only one state-variable, to one with actions that affect several. Asset values follow geometric Brownian motion or jump-diffusion processes with multiple generating sources of jumps. The Markov-chain numerical methodology we provide can handle sequential controls. Although we report the results with open-loop policies, the approach can be readily extended to accommodate dependency among the controls.

Suggested Citation

  • S H Martzoukos, 2009. "Real R&D options and optimal activation of two-dimensional random controls," Journal of the Operational Research Society, Palgrave Macmillan;The OR Society, vol. 60(6), pages 843-858, June.
  • Handle: RePEc:pal:jorsoc:v:60:y:2009:i:6:d:10.1057_palgrave.jors.2602627
    DOI: 10.1057/palgrave.jors.2602627
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