Real Options Theory: An Alternative Methodology Applicable to Investment Analyses in R&D Projects

Introduction

Conventional research and development (R&D) long term investment evaluation methods, such as the Net Present Value (NPV) and the Return on Investment (ROI) methods sustain basic shortcomings. These methods ignore outcome uncertainty, the choice of investment timing and the irreversibility of resource commitment, although being regarded and used by project managers for some time.

R&D project evaluation is often complex, due to substantial uncertainty found in different project phases, including the research, marketing and strategic planning and alignment phases. The stages can be sequentially evaluated through the differentiation between the many phases of an R&D program.

Each stage provides a gateway into the next stage. In addition, the time spent in each R&D phase affords the collection of other, relevant information to program evaluation. Essentially, each stage offers the manager an option to invest or not to invest in the next – and usually more expensive – phases of the R&D program, becoming an intricated and fundamental decision in the project management scope.

The value of technological “options” has been repeatedly used as a qualitative argument by researchers by the private and public sectors both, in supporting long-term strategic investigation. The technological option is the value of the opportunity broached by an R&D project in its initial stage, to invest later in a new technological area. Unfortunately, traditional empirical methods basing on cash flow estimates totally ignored the value of such opportunities; thus, risk research projects entailing substantial expected long-term returns were unduly penalized. Long term research has been traditionally supported at more modest levels than those preferred by their supporters.

Conversely, scenario-building and decision tree analyses are also often-used methods for the evaluation of R&D projects, since both allow for risk estimation in evaluation via the simplification of the complex return on risky projects problem. However, these traditional models show flaws as concerns the investment’s potential profitability.

For this purpose, the Real Options Theory (ROT) has been given growing attention in financial theory and innovation management. Through the lenses of the ROT, the interaction among irreversibility, flexibility and uncertainty entails considerable difference in the evaluation of an investment alternative and should be considered in the pricing process. Modeling managerial uncertainties and flexibilities available during a project’s life cycle is of the essence to establish what an investment risk is, reaching to an upper-level, qualified strategic context, enabling robustness to decisions made on investment and other issues when approaching project management processes and associated planning tasks.

The ROT is used to evaluate real assets, that is, those not traded in the marketplace. Capital investment projects, intellectual property evaluation, sources of natural resources and research and development project evaluation are examples of real assets that can be evaluated using this theory. A real option is the flexibility a manager has to make decisions involving real assets. As new information is obtained and cash flow uncertainties are cleared, managers can make decisions that will positively influence the project’s final value (Dixit & Pindyck, 1994).

The decisions managers often have to contend with are: What is right time to invest, abandon or temporarily stop a project? When should a project’s operating characteristics be changed, and also when should an asset be replaced by another? Thus, a capital investment project can be regarded as an ensemble of real options on a real asset: the project. This supporting context for better level of project management scope decisions can be regarded as an update of PM fundamentals and methods, as presented by institutional patronage of PMI and associated practitioners´ applications (PMBoK, 2018). As new aspects and events from the market happen, changes and competitive situations are imposed, a demanded scenario for practical application of scientific knowledge, such as project management must be permanently reviewed, and ROT can be integrated as a perspective theoretical field in this case.

Throughout this paper, the authors will seek to produce theoretical and empirical evidence using Geske’s (1979) model, as adapted for real situations by Kemma (1993) and designated by Perlitz, Peske and Schrank (1999) as an alternative methodology to evaluate compounded options.