Real Option Analysis, Managerial Decision Making & R&D projects

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Contents

Chapter 1 Introduction4

1.1 Background4

1.2 Basic Phenomenon of Interest5

1.3 Potential Benefit of Research6

1.4 Application of Real Option Analysis8

1.5 Problem Description and Objective15

1.6 Definition16

1.7 Theoretical Framework17

1.7.1 Binomial Model17

1.7.2 Black-Scholes Formula19

1.8 Basic Research questions21

1.9 Significance of Research21

1.10 Hypotheses22

1.11 Ethical Concerns24

1.12 Time Scale25

1.13 Structure of the Dissertation26

Chapter 2 Literature Review28

2. 1 Business Environment28

2.2 Real Option Analysis29

2.2.1 Concept29

2.2.2 Theory29

2.2.3 Traditional Valuation Techniques31

2.3 Evidence of practical application of Real Options Analysis32

2.4 Previous Survey conception33

2.5 Valuation34

2.7 Real Option thinking36

2.8 NPV mechanics of Real Options Analysis (ROA)38

2.9 Valuation of Research & Development Projects40

2.9.1 Characteristics of R&D Projects46

2.9.2 Problem Classification in Valuation of R&D Investments47

2.9.3 Application of Options Analysis to R&D Project Valuation49

2.10 Options a Manager may use55

2.10.1 Option to defer56

2.10.2 Time-to-build option57

2.10.3 Option to alter operating scale57

2.10.4 Option to abandon57

2.10.5 Option to growth57

2.11 Management interest in ROA58

2.12 Another Benefit of ROA for Managers59

References61

Bibliography64

INTRODUCTION

1.1 Background

Real Option Analysis (ROA) is a structure for analyzing flexibly in projects by giving managers tools to react to uncertainty. Managers understand the risk inherent in projects due to the uncertainties, which clearly indicates that options are always on their mind when considering how and when to invest in a project (Barman and Nash, 2007).

The above proposition addresses high-risk decisions such as, what evolving technology projects to invest in and on what projects to terminate are critical decisions in the domestic and global economy. ROA may be useful in prioritizing and analyzing investment opportunities for companies seeking to attain strategic gain. Real option analysis lets managers to comprehend the vibrant influence of risk and the contingent temperament of consequential investment choices, both of which are expected to be of immense significance to managers (Kulatilaka, Balasubramanian & Storck, 1999).

ROA is valuable for organizing managers' analysis of the tactical worth of an investment entailing an option; the application of ROA permits a rational and instinctive explanation of the investment products (Benaroch & Kauffman, 2000). The value produced by a project can be clarified reasonably and impartially by managers and will be accessed from industry to industry (Taudes, Feurstein & Mild, 2000).The ROA concept is similar to adaptive management concept (Holling 1978), which, like ROA provides as structured, iterative process of optimal decision making in the face of uncertainty. Both have an aim to reduce uncertainty over time via system monitoring or mathematical modeling. While there are differences between the two, the two could blend rather harmoniously. The point here, is that the concepts are not that far apart and provide managers with decision-making tools that simultaneously maximizes profit by allowing the manager to gain information either passively or actively. Both improve future management decisions (Stankey & Allan 2009).

The importance of real options analysis has gained in the last decade is that the most accepted methodology in the financial evaluation project which is the discounted cash flow projections based on future assumes that these follow a predetermined path that does not incorporate the changes that lie ahead (Luerhman 1998). One of the problems of the analysis of real options, apart ...