Real options applications to assess the impact of public funding on r and d projects from a double perspective: the private company and the funding body

Abstract

For many decades, Net Present Value (NPV) has been the main tool used by companies to assess the future economic revenues of projects and their consequently attractiveness. To some extent, this tool made sense as projects seemed to be predictable: for instance, a shoe factory would produce shoes, at a higher or lower yield, with some uncertainty on inputs’ price or demand, but the factory itself would be easy to model. If some hypotheses are met, such as the input total cost below or the demand above a certain threshold, the factory would work. No more decisions are relevant and NPV perfectly catches the rationale of the economics underlying this project. As NPV usage became extensive, it was extrapolated to less predictable project returns in which the economic rationale would not apply. In these cases, an error was introduced into the valuation allowing companies to make not-optimal decisions. One of the most representative cases of this idea are the Research and Development (R&D) projects. Contrary to the shoe factory case, a R&D project presents many options the company can take during the lifetime of the investment. By nature of these R&D projects, the initial investment is decided many years in advance the demand is forecasted or even if the technical success of the project is proven. During the development of the technology or product, additional information is usually gathered from market perspectives and potential future suppliers or customers. However, there is an increasing risk in parallel of another company launching to the market a better technology or product, becoming the initial investment less attractive, useless or even obsolete.