Valuation of an R&D project with three types of uncertainty

Abstract

This paper develops an R&D decision-making model in the real options framework. The model is generic enough to capture three types of uncertainty in an R&D project, namely, uncertainty of research duration and costs, market value of technology, and a competitor’s technology development. I derive analytical solutions, which help practitioners and researchers to evaluate various cases of R&D investment. Further, by analyzing the model with a wide range of parameter values, I reveal the following effects of the three types of uncertainty on R&D investment: higher uncertainty of research duration and costs, unlike market value uncertainty, speeds up investment, especially combined with a higher risk of competition. The investment timing can be U-shaped in the strength of competition because of the trade-off between the preemptive investment effect and the decreased project value effect. These results can account for empirical findings about the uncertainty–investment relation in industries with high R&D intensity and severe competition.