Budgeting Capital for R & D: An Application of Option Pricing

This paper presents the insight that R&R investments are natural options, and examines the extent to which they can be valued using currently available option pricing models. The nature of the industrial research effort determines whether the appropriate model is based on a diffusion process or a jump process. The option model based on the former is sufficiently developed to satisfactorily deal with the direct benefits of R&D, while the model base on the latter presents several problems. Furthermore, indirect benefits are not captured in these models. These applications and shortcomings are examined in detail in the hope of not only indicating a new direction for analysis of R&D investment decisions, but also pointing out the need for further scholarly research to deal more fully with this very interesting problem