Modeling Sequential R&D Investments: A Binomial Compound Option Approach for Management Accounting

• In Event: SESSION 6C: Management Accounting

Abstract

Valuing (sequential) R&D projects has received much attention in academia and corporate practice, especially in industries like the pharmaceutical sector where R&D is key to long-term success. Although practitioners generally acknowledge the potential of valuing real options, numerous studies have shown that real options analysis is—at best—an auxiliary valuation tool in an R&D manager’s method set. Other studies, however, show that, if applied, the real options approach can have a debiasing effect on R&D managers’ resource allocation decisions. Academia is thus challenged to develop more adequate real option models to boost acceptance in corporate practice. In this paper, we therefore propose a heuristic binomial approach to modeling sequential R&D investments. More specifically, we present a compound real option approach, simplifying the existing valuation methodology. Based upon the same set of assumptions as prior models, we show that the number of computational steps for valuing a z-fold compound option can be reduced to a single step. We demonstrate the applicability of our approach using the real-world example of valuing a new drug application (NDA). Overall, our work thus provides a heuristic framework for fostering the adoption of binomial compound option valuation techniques in R&D management.

Authors

• Daniel Reimsbach, University of Duesseldorf

• Bastian Hauschild, University of Duesseldorf