# Valuation of R&D Investment Opportunities with the Threat of Competitors Entry in Real Option Analysis

- 423 Downloads
- 1 Citations

## Abstract

This paper provides a real option methodology in order to value a pioneer’s R&D investment opportunity allowing for more potential competitors to enter in the market. To incorporate this competitive dimension, we assume that the pioneer may lose the “competitive dividends” if the real option is not exercised. According to Majd and pindyck (1987) (Journal of Financial Economics 18(1):7–27), in a real options context, “dividends” are the opportunity costs inherent in the decision to defer an investment project and so deferment implies the loss of project’s cash flows. Concerning this, Trigeorgis (1996) (Real Options: Managerial Flexibility and Strategy in Resource Allocation, The MIT Press, Cambridge, (1996) incorporates the preemption effect through the “competitive dividends” which are the cash flows that can be eroded by anticipated competitive arrivals. In particular way, we propose the valuation of a pioneer’s R&D investment assuming that the Development cost can be spent in two moments: \(t_2\) or \(t_3\). If the Development cost is realized in \(t_2\) no firms enters in the market since the rivals’ R&D plan is not yet concluded otherwise, if the Development cost is delayed until time \(t_3\) waiting better market conditions, other rivals may enter in the market and so the opportunity costs, namely dividends, increase. Moreover, we analyze the optimal timing to realize the Development investment, i.e. we determine the conditions for which the pioneer prefers to invest the Development cost at time \(t_2\) or \(t_3\).

## Keywords

Real options R&D Monte Carlo methods Competitive dividends## JEL Classification

G13 O32 C15 D40## References

- Armada, M. R., Kryzanowsky, L., & Pereira, P. J. (2007). A modified finite-lived American exchange option methodology applied to real options valuation.
*Global Finance Journal*,*17*(3), 419–438.CrossRefGoogle Scholar - Armada, M. R., Kryzanowsky, L., & Pereira, P. J. (2011). Optimal investment decisions for two positioned firms competing in a duopoly market with hidden competitors.
*European Financial Management*,*17*(2), 305–330.CrossRefGoogle Scholar - Brandão, L. E., & Dyer, J. S. (2005). Decision analysis and real options: A discrete time approach to real option valuation.
*Annals of Operations Research*,*135*(1), 21–39.CrossRefGoogle Scholar - Carr, P. (1988). The valuation of sequential exchange opportunities.
*The Journal of Finance*,*43*(5), 1235–1256.CrossRefGoogle Scholar - Carr, P. (1995). The valuation of American exchange options with application to real options. In Lenos Trigeorgis (Ed.),
*Real options in capital investment: Models, strategies and applications*. London: Westport Connecticut.Google Scholar - Cortazar, G. (2001). Simulation and numerical methods in real options valuation. In E. S. Schwartz & L. Schwartz (Eds.),
*Real options and investment under uncertainty: Classical readings and recent contributions*(pp. 601–620). Cambridge: MIT Press.Google Scholar - Cortelezzi, F., & Villani, G. (2009). Valuation of R &D sequential exchange options using Monte Carlo approach.
*Computational Economics*,*33*(3), 209–236.CrossRefGoogle Scholar - Dias, M. A. G. (2004). Valuation of exploration and production assets: An overview of real options models.
*Journal of Petroleum Science and Engineering*,*44*(1–2), 93–114.CrossRefGoogle Scholar - Fudenberg, D., & Tirole, J. (1985). Preemption and rent equalization in the adoption of new technology.
*Review of Economic Studies*,*52*, 383–401.CrossRefGoogle Scholar - Gamba, A. (2003). Real options valuation: A Monte Carlo approach.
*Working Paper Series 2002/03*, Faculty of Management, University of Calgary.Google Scholar - Grenadier, S. R. (1996). The strategic exercise of options: Development cascades and overbuilding in real estate markets.
*The Journal of Finance*,*51*(5), 1579–1653.CrossRefGoogle Scholar - Huisman, K. J. M. (2001).
*Technology investment: A game theoretic real options approach*. Boston: Kluwer Academic Publishers.CrossRefGoogle Scholar - Lambrecht, B., & Perraudin, W. (2003). Real options and preemption under incomplete information.
*Journal of Economic Dynamics and Control*,*27*(4), 619–643.CrossRefGoogle Scholar - Majd, S., & Pindyck, R. S. (1987). Time to build, option value and investment decisions.
*Journal of Financial Economics*,*18*(1), 7–27.CrossRefGoogle Scholar - Margrabe, W. (1978). The value of an exchange option to exchange one asset for another.
*The Journal of Finance*,*33*(1), 177–186.Google Scholar - McDonald, R., & Siegel D. R. (1986). The value of waiting to invest.
*Quarterly Journal of Economics*,*101*, 707–727.Google Scholar - McDonald, R. L., & Siegel, D. R. (1985). Investment and the valuation of firms when there is an option to shut down.
*International Economic Review*,*28*(2), 331–349.CrossRefGoogle Scholar - Thijssen, J. J. J. (2010). Preemption in a real option game with a first mover advantage and player-specific uncertainty.
*Journal of Economic Theory*,*145*, 2448–2462.CrossRefGoogle Scholar - Trigeorgis, L. (1996).
*Real options: Managerial flexibility and strategy in resource allocation*. Cambridge: The Mit Press.Google Scholar - Weeds, H. (2002). Strategic delay in a real options model of R &D competition.
*Review of Economic Studies*,*69*(3), 729–747.CrossRefGoogle Scholar