RESEARCH PAPER INVESTMENT RESEARCH REPORT

Investment Research report



International Research Organization

Introduction

Referring the role of Real Options Analysis (ROA) in making decisions on science and technology (S&T) investments. ROA is a method for helping to make investment decisions where outcomes are uncertain. It seeks to quantify numerically each of the investment options available in a particular situation. It could have potential for application to Government S&T investment decisions in two ways: first as a qualitative mechanism to simplify complex investment decisions by breaking them down into its component individual stages; and second to quantify the outcomes at each stage on the basis of market information and probability of success. ROA gives the opportunity to revise future investment decisions at particular strategic points in response to new information or changing circumstances.

Background

ROA compared with other methods

In principle, ROA offers potential advantages over traditional net present value (NPV) and discounted cash flow (DCF) approaches, both of which may lead to under-investment in high-risk areas. It places a positive value on risk by exploiting the opportunity to phase investments and stage key decisions so as to (i) allow termination of initial exploratory R&D projects which turn out to be unsuccessful, and (ii) invest more in those showing positive future prospects. By contrast, NPV and DCF view risk negatively and, by ignoring the option approach, impose higher discount rates to 'adjust' for higher risk, thus reducing the value of future expected income streams.

The intuition behind this potential outcome is as follows. Traditional investment appraisal techniques can be conceived as being concerned with a one-shot valuation of an investment in an “asset”. The initial investment is followed by a series of (often) uncertain cash flows over time. DCF analysis is the industry standard valuation technique. It takes account of the time-value of money through the use of a 'risk free interest rate', and of riskiness by adding a risk premium to the risk free rate in discounting future cask flows.

This approach neglects the insight which arises from recognising the phased nature of many investment decisions, which may begin with exploratory phases before final “asset” invetsment decisions are made. Many investment projects have in effect an “options phase” prior to the “asset phase”. During the “options” phase, investments are not being made in an asset to generate a stream of cash flows but to establish the opportunity (but not the obligation) to subsequently invest in such an asset. The investment in R&D is effectively an “options” - ie an exploratory - phase, which is the necessary precursor in order to allow future investment in the final “asset” phase - which in this case is the future commercialization project if the R&D is succesful.

NPV techniques are inappropriate to value projects in options phases, such as R&D investment, because first they do not take into account the value of the option phase, and second they neglect the fact that commitments to future investments are contingent on how the future ...