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

Abstract

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

Herath, Hemantha and Bremser, Wayne G., Real-Option Valuation of Research and Development Investments: Implications for Performance Measurement (May 16, 2018). Managerial Auditing Journal, Volume 20, No 1, pp. 55-72 (2005), Available at SSRN: https://ssrn.com/abstract=3179724

Hemantha Herath (Contact Author)

Brock University ( email )

St. Catharines, Ontario L2S 3A1
Canada

Wayne G. Bremser

Villanova University ( email )

Villanova, PA 19085
United States

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