THE ASSESSMENT OF R&D EXPENDITURES VIA REAL OPTIONS
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Introduction 9
Urgency of the problem 9
The research overview 11
Chapter 1. Theoretical overview 13
1.1. Treating R&D as a real option 13
1.2. R&D valuation techniques via real options 17
1.2.1. Binary tree single period model 17
1.2.2. Compound option model 19
1.3. Industrial specificities 28
1.3.1. Sources of financing R&D 28
1.3.2. Accounting indicators of R&D 32
1.3.3. Non-Accounting indicators of R&D 36
Chapter 1 Summary 42
Chapter 2. Theoretical implementation 43
2.1. The model for industrial R&D 43
2.2. Data 45
2.3. Empirical validation 49
Chapter 2 Summary 61
Conclusion 62
References 65
Appendix 73
Urgency of the problem 9
The research overview 11
Chapter 1. Theoretical overview 13
1.1. Treating R&D as a real option 13
1.2. R&D valuation techniques via real options 17
1.2.1. Binary tree single period model 17
1.2.2. Compound option model 19
1.3. Industrial specificities 28
1.3.1. Sources of financing R&D 28
1.3.2. Accounting indicators of R&D 32
1.3.3. Non-Accounting indicators of R&D 36
Chapter 1 Summary 42
Chapter 2. Theoretical implementation 43
2.1. The model for industrial R&D 43
2.2. Data 45
2.3. Empirical validation 49
Chapter 2 Summary 61
Conclusion 62
References 65
Appendix 73
Research and development (also R&D) is the number of different activities of the company, devoted to the acquisition of innovative products and services. R&D helps the company to compete on the market and also provides advantages, when the company correctly uses the results. Nevertheless, each company has its own level of investment in R&D - the share varies not only by industry, but also by companies within the same industry. According to the latest research, the most R&D intensity companies are: Celgene Corporation (Pharmaceuticals), Roche Holding AG (Pharmaceuticals), Merk&Co (Pharmaceuticals), Intel (Semiconductors), Facebook Inc. (Software and Services) (Jaruzelski, Chwalik, & Goehle, 2018).
Since the competitiveness of a company is determined, among other things, by existing developments that are different from competitors, R&D occupies an important place in the company's activities. For some companies, investment in R&D is critical to their business (for example, pharmaceutical and biopharmaceutical companies). At the same time, R&D is a significant financial investment, the assessment of the potential of which is important for the company. Currently, there are several methods of R&D estimation. One of the most suggested is the value, estimated by the market: this is possible due to the attitude of investors to R&D as a source of future cash flow generation (Eberhart , Maxwell , & Siddique , 2004). This idea is also supported by the research done (Cohen, Diether, & Malloy, 2013) on the topic of market evaluation on R&D capacity via the stock price of the company. Palmon D. and Yezegel A. (Palmon & Yezegel, 2012) also confirmed by their research that R&D is important for assessing the attractiveness of a company to investors. Their approach, however, was focused specifically on how analysts interpret a firm with higher R&D investments (and then provide information to the market). The same approach with market valuation was applied by (Zhang & Toffanin, 2018), but with the focus on the special aspect of the existing information environment of the firm, which has direct influence on the market valuation of the company. However, the limitation of the market value approach is the consideration of only one aspect of uncertainty.
The second approach of evaluation of Research and Development, covers the aspect of existing on the market the high level of uncertainty of the variety of sources- this evaluation is done applying Real Options theory. Many modern academic authors support this method, pointing to its more accurate and at the same time applicable assessment for the company. Nishihara M. identifies three sources of uncertainty - in addition to market, also technological and competitive, which all should be taken into account (Nishihara, 2018). Based on these uncertainties, the author creates the model of R&D estimation, treating it as a real option for the company. The idea of R&D estimation via Real Options is also supported by another research, connected with the deeper analysis of the factors described above - the Real Options approach allows to make a more flexible decision regarding the further development of the company and its projects, and for some companies to abandon the project altogether (Metelski, Mihi-Ramirez, & Arteaga-Ortiz, Research and Development Projects Upon Real Options View, 2014). For some specific cases Real Options application could be the only possible way of assessment of the true value of the project - for the concrete company or industry, since R&D expenditures vary significantly and the formula could not be appropriate with the existence of specific uncertainties (Lynch & Shockley, 2016) and (Hauschild & Reimsbach, Modeling sequential R&D investments: a binomial compound option approach, 2015).
Application of Real Options to the assessment of Research and Development provides significant flexibility to the managers and investors. It is an important part of the investing process. The existing models and proposals on valuation estimate narrow areas and spheres, specific industries, even specific cases of companies. This problem was covered by (Bukhvalov, Loukianova, Nikulin, & Okulov, A Real Options Model for Analysis of industrial R&D Expenditures, 2018) via creating a model that takes into account more general aspects for assessing the intensity of R&D in large companies. The model developed is applicable for the valuing R&D and can be used by managers. Though the work provides an overview of the methodology for assessing the intensity of R&D for industries, the authors identified several limitations related to the specifics of the model itself - a limitation on R&D financing from operating profit was considered. That is why the research in the field of the Real Options model construction with the different sources of financing is acute. What is more, the research done had some limitations on the data, which also would be considered within the study.
Since the competitiveness of a company is determined, among other things, by existing developments that are different from competitors, R&D occupies an important place in the company's activities. For some companies, investment in R&D is critical to their business (for example, pharmaceutical and biopharmaceutical companies). At the same time, R&D is a significant financial investment, the assessment of the potential of which is important for the company. Currently, there are several methods of R&D estimation. One of the most suggested is the value, estimated by the market: this is possible due to the attitude of investors to R&D as a source of future cash flow generation (Eberhart , Maxwell , & Siddique , 2004). This idea is also supported by the research done (Cohen, Diether, & Malloy, 2013) on the topic of market evaluation on R&D capacity via the stock price of the company. Palmon D. and Yezegel A. (Palmon & Yezegel, 2012) also confirmed by their research that R&D is important for assessing the attractiveness of a company to investors. Their approach, however, was focused specifically on how analysts interpret a firm with higher R&D investments (and then provide information to the market). The same approach with market valuation was applied by (Zhang & Toffanin, 2018), but with the focus on the special aspect of the existing information environment of the firm, which has direct influence on the market valuation of the company. However, the limitation of the market value approach is the consideration of only one aspect of uncertainty.
The second approach of evaluation of Research and Development, covers the aspect of existing on the market the high level of uncertainty of the variety of sources- this evaluation is done applying Real Options theory. Many modern academic authors support this method, pointing to its more accurate and at the same time applicable assessment for the company. Nishihara M. identifies three sources of uncertainty - in addition to market, also technological and competitive, which all should be taken into account (Nishihara, 2018). Based on these uncertainties, the author creates the model of R&D estimation, treating it as a real option for the company. The idea of R&D estimation via Real Options is also supported by another research, connected with the deeper analysis of the factors described above - the Real Options approach allows to make a more flexible decision regarding the further development of the company and its projects, and for some companies to abandon the project altogether (Metelski, Mihi-Ramirez, & Arteaga-Ortiz, Research and Development Projects Upon Real Options View, 2014). For some specific cases Real Options application could be the only possible way of assessment of the true value of the project - for the concrete company or industry, since R&D expenditures vary significantly and the formula could not be appropriate with the existence of specific uncertainties (Lynch & Shockley, 2016) and (Hauschild & Reimsbach, Modeling sequential R&D investments: a binomial compound option approach, 2015).
Application of Real Options to the assessment of Research and Development provides significant flexibility to the managers and investors. It is an important part of the investing process. The existing models and proposals on valuation estimate narrow areas and spheres, specific industries, even specific cases of companies. This problem was covered by (Bukhvalov, Loukianova, Nikulin, & Okulov, A Real Options Model for Analysis of industrial R&D Expenditures, 2018) via creating a model that takes into account more general aspects for assessing the intensity of R&D in large companies. The model developed is applicable for the valuing R&D and can be used by managers. Though the work provides an overview of the methodology for assessing the intensity of R&D for industries, the authors identified several limitations related to the specifics of the model itself - a limitation on R&D financing from operating profit was considered. That is why the research in the field of the Real Options model construction with the different sources of financing is acute. What is more, the research done had some limitations on the data, which also would be considered within the study.
The research aim is suggesting the model for the assessment of industrial R&D expenditures via the application of Real Options. The model might be applicable by the investors and financial managers in order to estimate the value of R&D as a real option. This will be beneficial due to the existence of the flexibility of the decision. What is more, the model can be used as the indicator for the researcher to identify whether the investments into R&D are sufficient or over-/under- invested. The research conducted shown that for the case of Real Options the Real Options method of evaluation could be applied, since investing in R&D gives the company right to acquire assets for the competitiveness in the future (for example, patents). Because of the uncertainty about the outcome of the R&D expenditures, companies apply the method on several stages, treating R&D as the option to grow or to abandon. For the assessment it is possible to apply the approach of the single period model, the model of compound option or the simulation of the outcomes of R&D. All methods are useful and applied in different situations, depending on the aim of the evaluation and availability of information. The model suggested within this paper is applied to the cases of the assessment of the industrial level of R&D expenditures, when an overview on the competitiveness within the industry is needed and there is no internal information.