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Framework for R&D decisions:
A real options approach
Norwegian University of Science and Technology, Faculty of Social Sciences and Technology Management, Department of Industrial Economics and Technology Management.
Norwegian University of Science and Technology, Faculty of Social Sciences and Technology Management, Department of Industrial Economics and Technology Management.
2011 (English)MasteroppgaveStudent thesis
Abstract [en]

This thesis proposes the use of the hybrid real options framework presented by Neely (1998) to facilitate valuation of, and decision making in, R&D projects. The framework combines the favorable benefits from Decision Analysis (DA) and financial option theory, which are the two most commonly applied methodologies for real option assessments. The combined framework addresses the DA’s incapability for handling a fluctuating discount rate in a practical way, and the financial option theory’s requirement of historical data, that is generally unavailable for unique R&D projects. The value of flexibility is estimated by distinguishing two types of risks; project and market risks, where DA and option theory are applied, respectively. The hybrid real options is a practical and at the same time accurate approach. It allows the use of the risk-free rate as a consistent constant discount rate. In addition, the valuation becomes organized in the sense that the process is divided in a technical and financial part. Hence, technical and financial experts can apply their knowledge independently. However, the framework’s use of a decision tree restricts the complexity of the model as it could turn too comprehensive to be applicable in an assessments context. When exemplifying the framework, an option to continue or abandon further development of CCS is modelled. The framework values the CCS project - at best - when continuing the development. This returns an expected profit of NOK 28 billion. However, risk analysis yields a probability close to 50% that the project returns a loss of similar magnitude. The estimated expected value is NOK 860 million higher compared to the traditional Net Present Value methodology. Hence, the value of including the inherent flexibility of an R&D project is significant. In this context, this difference represents the option value in the decision of whether to implement or not. The sensitivity analysis concludes that the annual growth in production stand out as the most important variable for the expected value of Carbon Capture and Storage (CCS). This is rather intuitive as new production yields possibly large emissions of CO2, which is the main benefit driver for the CCS technology. In addition, the share of unconventional oil in new production, that we assume would require CCS, is essential. We extend the framework of Neely (1998) by incorporating simple game theory, which proved to introduce a significant value change because of the possible strategic advantages of a CCS involvement. The game considered only a valuation of the First Mover Advantage (FMA) and showed that the strategic value is superior to the flexibility value by more than NOK 50 billion. The dominant strategy is to continue further development of CCS, which then values the project at NOK 48.1 billion. Now, risk analysis concludes that there is a probability of more than 70% to achieve a positive return from the CCS R&D project. For further work, a more detailed consideration of game theory is suggested. An interesting topic would be Statoil’s impact on its own technology supply environment - does it really make a difference that Statoil is engaged in the CCS field, or should it let others do the hard work? In addition, inclusion of other uses of the CCS technology would yield a more complete valuation.

Place, publisher, year, edition, pages
Institutt for industriell økonomi og teknologiledelse , 2011. , 119 p.
Keyword [no]
ntnudaim:5986, MTIØT Industriell økonomi og teknologiledelse,
URN: urn:nbn:no:ntnu:diva-15045Local ID: ntnudaim:5986OAI: diva2:473562
Available from: 2012-01-06 Created: 2012-01-06

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