The potential benefits of innovative activities are twofold, first extra profits derived from increased sales and/or higher prices for superior production and from lower costs and /or increased sales from superior production processors. Conventional project appraisal methods can be used to compare the value of these benefits against their cost. Second, accumulated form specific knowledge (learning; intangible assets) that may be useful for the development of future innovations (e.g. new uses for solar batteries carbon fibres, robots, word processing). This type of benefit is relatively more important in R&D projects that are more long term and fundamental.
Conventional techniques cannot be used to assess the second type of benefits because it is an option, in other words it creates the opportunity for the firm to invest in a potentially profitable investment but the realization of the benefits still depend on a decision to commit further resources. Conventional project appraisal technique cannot evaluate options:
Why conventional financial evaluation methods do not work with investments in technology?
The following text was written by the Professor of Finance at the Sloan School of Management at MIIT.
Suppose a firm invests in negative NPV (net position value) project in order to establish a foot hold in an attractive market. Thus, a valuable second stage investment is used to justify the immediate project. The second stage must depend on the first. If the firm could take the second project without having taken the first, then future opportunity should have no impact on the immediate decision.
At first glance this may appear to be just another forecasting problem. Why not estimate cash flows for both stages and use discounted cash flows to calculate the NPV for the two stages taken together?
You would not get the right answers. The second stage is an option, a conventional discounted cash flow does not value options properly. The second stage is an option because the firm is not committed to undertaking it. It will go ahead if the first stage works and the market is still attractive. If the first stage fails or if the market sours, the firm can stop after stage 1 and cut its losses. Investing in stage 1 purchasers and intangible assets: a call option on stage 2.If the option’s present value offsets the first stage negative NPV, in the first stage, is justified.
DCF (discounted cash flow) is readily applied to cash cows, — relatively safe business held for the cash they generate. It also works for engineering investments such as machine replacement where the main benefit is that of reduced cost in a defined activity.
DCF is less helpful in valuing businesses with substantial growth opportunities or intangible assets. In other words it is not the whole answer when options account for a large fraction of a business value.
DCF is no help at all for pure research and development. The value of R&D is almost all option value, intangible assets, value usually options value.
The inherent uncertainty in most R&D projects limits the ability of managers to predict the outcomes and benefits of projects. Research suggests that changes on R &D plans and goals are commonly being driven by external factors, such as technological breakthroughs as well as internal factors such as changes in the project goals. Together the impact of changes to project plans and goals overwhelm the effects of the quality of formal project’s planning and management. This reality is consistent with the real options approach to investing in R&D because investments are sequential and managers have some influence on the timing, resourcing and continuation or abandonment of projects at different stages.
Source: Managing Innovation