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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 for evaluating R&D investment opportunities assuming that potential competitors can en- ter in the market. As it is well known, R&D investments are made often in a phased manner and so each stage creates an opportunity (option) for subsequent investment. Therefore, R&D projects can be consid- ered as ‘Compound Exchange Options' in which investments present uncertainty both in the gross project value and in costs. According to Majd and Pindyck (1987), in a real options context, “div- idends” are the opportunity costs inherent in the decision to defer an investment project and so deferment implies the loss of project's cash flows. Moreover, Trigeorgis (1996) incorporates the preemption effect through the “competitive dividends” which are the cash flows that can be eroded by anticipated competitive arrivals. In this paper we propose to value, using Montecarlo simulation, the R&D investments of a pioneer firm assuming that the Development cost can be spent in two moments: t2 or t3. If the Develpment cost is realized in t2 no firms enters in the market since the rivals' R&D plan is not yet concluded otherwise, if the investment D is delayed at time t3 waiting better market conditions, other rivals can enter in the market and so the opportunity costs (“dividends”) increase.

Suggested Citation

  • Giovanni Villani, 2009. "Valuation of R&D Investment Opportunities with the Threat of Competitors Entry in Real Option Analysis," Quaderni DSEMS 21-2009, Dipartimento di Scienze Economiche, Matematiche e Statistiche, Universita' di Foggia.
  • Handle: RePEc:ufg:qdsems:21-2009
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    File URL: http://www.economia.unifg.it/sites/sd01/files/allegatiparagrafo/29-11-2016/q212009.pdf
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    Keywords

    Real options; R&D; Monte Carlo methods; Competitive dividends.;

    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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