Application Of Real Options Approach To R&D Investment Decision Making In Agilent

Research and Development plays an important role in implementingcompany’s long term strategy, so reasonably valuing R&D investmentopportunities becomes essential when making strategic decision.AgilentTechnologies is the world premier measurement company, in order tomaintain its technology leadership, R&D projects in this kind of Hi-Techcompany are usually with big uncertainty and highly risky. It has been widelyaccepted that conventional net-present-value (NPV) method is not able todeal with uncertainty well and capture the management flexibility, whichmay result in projects being undervalued and wrong decision being made.While real option method has advantages compared with NPV method in thiskind of situation and has been widely adopted by lots of company inevaluating their R&D investment opportunities.There are articles which do a good job of explaining why real optionapproach is useful in capturing what conventional net-present-value (NPV)analyses do not, and books which introduce option pricing models. But mostexecutives get stuck at that point. How to use this theory as real numbers inprojects? This thesis presented a framework based on Black-Scholes optionpricing model, which bridges the gap between the practicalities of real-worldprojects and higher mathematics associated with option-pricing theory, andgave detailed steps on how to use the framework in R&D project budgetingto help executives make the right decision. In the first part of the article, conventional net-present-value (NPV)method currently being used in Agilent Technologies is questioned, and realoption method is brought out as a solution. After that, a framework whichcombines real option method with NPV method is created base onBlack-Scholes option pricing model, and detailed implementation steps arepresented to make this framework more easier to use. To calculate volatility,which is the most important parameter in real option method, logarithmiccash-flow returns approach, logarithmic present-value approach andmanagement assumption approach are recommended. To simplify the B-Soption pricing model, five parameters are combined into only two parametersso that the decision maker can easily use the B-S option-pricing lookup tableto get the option price. Finally, this framework is applied in real R&D projectevaluation and decision making in Agilent Technologies.Based on theory research and practice done in the company projects,real option method is proved to be useful as a complementarity toconventional project evaluation methods. And companies can benefit fromusing real option method by making reasonable decision.