Capturing the option value of R&D

Real options models capture the value of flexibility in R&D projects. This value lies in the fact that management always has the option to abandon the project if the results of R&D are not promising, thus limiting losses to the amount invested in the R&D phase. Traditional net present value (NPV) analysis fails to recognize this flexibility and therefore tends to under value R&D oppurtunities. The Black-Scholes model has been used extensively for financial potions, bur may be difficult to apply to R&D projects. Instead, it is suggested that the cost and revenue cash flows associated with implementing a project be used to measure the option value of R&D. This model captures the uncertainty associated with cash flow projections while simplifying some of the assumptions and data required for the Black-Scholes model.