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Valuation of R&D investments for new products: A real options approach focusing on key uncertainties

Firms make very significant investments in new product development (NPD) projects, yet the economic return on these investments is often uncertain. The technical success of NPD projects is one source of uncertainty, and also how the market (customers) will respond to the new product. Often there is flexibility that firms can exploit to deal with uncertainty. Real options models can represent this uncertainty and flexibility. This paper presents a real options approach for valuing early-stage NPD projects, which is practically applicable in a complex setting: many uncertainties about technology and market; the order in which uncertainties are resolved and decisions will be made, cannot be fully specified in advance; transparency of the method is key; and interdependencies among NPD projects exist. The approach, implemented through a spreadsheet model, has been developed by Philips Lighting and university researchers, and it has been applied to support large NPD investment decisions.