New Decision Tree Analysis (DTA) model for R&D project valuation

Innovation effectiveness depends very much on making smart choices, for instance regarding which R&D projects to choose during Roadmapping or Portfolio Management, which scenario to select for a Venture or New Business, how to include the high uncertainties usually involved in strategic and front-end innovation decisions, etc.

As such choices have a strong impact on the performance and sustainability of the business involved, choosing the appropriate valuation technique is crucial in capital investments, especially in R&D valuation. Because of the uncertainties involved in investment projects, traditional valuation methods are no longer suitable. In addition, in projects in which managers can react to incoming information about a project‘s progress and market conditions, and adjust their investment decisions accordingly, managerial flexibility further complicates the valuation process. The Net Present Value (NPV) method, a tool widely used by corporations to evaluate investments, does not capture the value of managerial flexibility underlying an R&D investment and also ignores uncertainty. Traditional Decision Tree Analysis (DTA), using discounted cash flows, overcomes this drawback but fails to adjust the discount rate in order to account for changes in the risk pattern of a project’s cash flows.

In this volume of the Innovation Flash we introduce a valuation approach for practitioners that is complex enough to improve (R&D) project valuation, so that uncertainties are appropriately handled, and to capture the value of managerial flexibility involved in investment projects, and at the same time simple enough for users to understand and implement it. A new DTA model incorporating the Real Options Approach has been developed to correct for these flaws and to handle both market and private uncertainties in such investment projects.

Read the complete article in our Innovation Flash: “Valuation approach for practitioners”