Real-Option Valuation of Research and Development Investments: Implications for Performance Measurement
Managerial Auditing Journal, Volume 20, No 1, pp. 55-72 (2005)
Posted: 29 May 2018
Date Written: May 16, 2018
The literature on R&D performance measurement identifies the need for an integrated performance measurement system for strategy implementation. R&D investment opportunities exhibit real option characteristics. Real options techniques can be used to value managers’ options to shelter investments from adverse effects and exploit upside potential. A firm that uses real options thinking and models takes an active risk management view. We develop a theoretical framework for R&D performance measures, incorporating real options to define strategic net present value, which values the plan to make R&D investments. We reason that the shift in valuation paradigms from a naïve net present value model to active risk management implicit in real options requires performance measures that reflect real option value. Based on our theoretical framework, we define strategic value created (SVC), which is based on residual income concepts. Since residual income is known to be superior to ROI in motivating goal congruence, we infer that SVC has similar advantages. We illustrate how SVC would be used as a performance measure for a new drug in the commercialization stage and consider several relevant questions. We also discuss how SVC could be used in a firm’s balanced scorecard.
Keywords: Residual Income, Performance Measures, Research and Development
JEL Classification: C00
Suggested Citation: Suggested Citation