FINANCE Corporate financial policy and R and D Management

In traditional investment analysis, a project or new investment should
be accepted only if the returns on the project exceed the hurdle rate—the
cost of capital that leads to a positive net present value. Several additional
aspects of real options are embedded in capital budgeting projects. The
first is the option to delay a project, especially when the firm has exclusive
rights to the project. The second is the option to expand a project to cover
new products or markets some time in the future.

Option to Delay a Project

Projects are traditionally analyzed using their expected cash flows and dis-
count rates at the time of the analysis; the net present value computed on
that basis is a measure of its value at that time. Expected cash flows and dis-
count rates change over time, however, and so does the net present value.
Thus, a project that has a negative net present value now may have a positive
net present value in the future, if expected cash flow rises or the discount rate
falls. In a competitive environment, in which individual firms have no special
advantages over their competitors in taking on projects, this may not seem
significant. In an environment in which only one firm, such as a firm with a
patent, can take on a project, barriers to entry, such as extensive advertising
or other restrictions, may create an unequal playing field. The changes in the
project’s value over time give it the characteristics of a call option.
In the abstract, assume that a project requires an initial investment, as
the R&D program, C. The present value of expected cash inflows com-
puted right now is PVCF. The net present value of this project is the differ-
ence between the two:

NPV = PVCF – C

Now assume that the firm has exclusive rights to this project for the
next nyears, and that the present value of the cash inflows may change
over that time, because of changes in either the cash flows or the discount
rate. Thus, the project may have a negative net present value right now, but

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66 DEBT, EQUITY, FINANCIAL STRUCTURE, AND THE INVESTMENT DECISION