R&D Cooperation in Real Option Game Analysis

Abstract

In recent years, the real option theory has been widely used in evaluating investment decisions in a dynamic environment. The market developments are complex and so the conventional NPV (Net Present Value) rule undertakes the value of a project because this method fails to take into account the market uncertainty, irreversibility of investment and ability to delay entry. The well accepted paradigm in real option theory states the equivalence between investment opportunities of firms and financial contingent claims, allowing for managerial flexibility.

Several models, such as Lee (1997); Shackleton and Wojakowski (2003); Trigeorgis (1991) and so on, are based on the assumption that the option exercise price, and so the investment cost, is fixed. But, particularly for the R&D investments, it is reasonable to consider that the evolution of the investment cost is uncertain. The R&D investment opportunity corresponds to an exchange option, i.e., the swap of an uncertain investment cost for an uncertain gross project value. The most important valuation models of exchange options are given in Armada, Kryzanowsky, and Pereira (2007); Carr (1988, 1995); Margrabe (1978); McDonald and Siegel (1985). In particular way, McDonald and Siegel (1985) value a simple European exchange option while Carr (1988) develops a model to price a compound European exchange option. Both models consider that assets distribute “dividends” that, in real options context, are the opportunity costs if an investment project is postponed (Majd & Pindyck, 1987).