PRIORITIES FOR FEDERAL INNOVATION REFORM

**PRIORITIZING LONG-TERM, STRATEGIC R&D PROJECTS**

**IN THE PUBLIC SECTOR**[^1]

**Nicholas S. Vonortas**

Center for International Science and Technology Policy

& Department of Economics

The George Washington University

*Nicholas S. Vonortas* is Deputy Director of the Center for
International Science and Technology Policy and Associate Professor at
the Department of Economics at the George Washington University. He
specializes in the economics of technological change and science and
technology policy.

**Abstract:** This paper proposes the use of an innovative methodology
(technology options approach) to choose among competing longer-term,
risky strategic R&D investments. This methodology explicitly accounts
for the uncertainty of long-term R&D and captures the value in terms of
opening up opportunities for private sector investment in new
technological areas.

R&D managers and public administrators have always defended the merits
of long-term research on qualitative arguments of technology options.
Recently, however, economists have formulated the methodological
foundations for appraising such arguments empirically. [It is time for
public R&D project managers and policy decision makers to carefully
consider the technology options approach to strategic R&D project
selection as it has the potential of liberating them from wearing
ideological battles.]{.underline}

Mailing Address: Nicholas S. Vonortas, CISTP, The George Washington
University, 2013 G Street, N.W., Suite 201, Washington, D.C. 20052

Tel: (202 994-6458

Fax: (202) 994-1639

e-mail: vonortas@gwu.edu

**1. Introduction**

Conventional methods for evaluating long-term investments in research
and development (R&D) such as net present value (NPV) and return on
investment (ROI) suffer from basic shortcomings. These methods largely
ignore the uncertainty of the outcome, the choice of timing of the
investment, and the irreversibility of committed resources. Given that
these factors are major characteristics of \"strategic\" long-term R&D,
inadequate accounting for them may seriously distort decision making
based on the potential benefits of investments in government sponsored
R&D programs.

We can now do much better by differentiating between the various stages
of a projected R&D program and evaluating the stages in sequence. Each
stage provides new scien­tific and technological input for the next. In
addition, the time spent in each R&D stage facilitates the collection of
other (e.g., market) information relevant to the appraisal of the
program. In essence, each stage provides the investor with an "option"
to invest or not in the next -- and usually more expensive -- R&D stage.
It is the earlier, \"strategic\" R&D stages that have presented most
analytical difficulties for conventional financial methods of ex ante
program appraisal.

The value of technological \"options\" has been repeatedly used as a
*qualitative* argument by research administrators in both the private
and the public sectors to support strategic, long-term research. A
technological option is the value of the opportunity opened up by an
early-stage R&D project to invest subsequently in a new technological
area. Unfortunately, tradi­tional empirical methods based on estimates of
future cash flows totally disregard the value of such opportunities,
thus often uneccessarily penalizing risky research projects with large
expected returns in the long term. Not surprisingly, technology
administrators have often been disenchanted with the decision-making
process on the basis of quantitative criteria. Long-term research has
traditionally been supported at more modest levels than its supporters
would prefer.

The technology options approach to R&D project selection is based on
recent advances in economic theory which allow a more proper accounting
of the merits and drawbacks of highly uncertain R&D programs. [By
explicitly recognizing the \"choice to invest\" aspect of earlier-stage
R&D projects, the technology options approach is expected to enhance the
ability of decision makers to justify long-term R&D investments of the
public sector.]{.underline}

**2. The Problem with the Conventional Approach**

Evaluating long-term strategic investment decisions is an inexact
science. By its very nature it involves decisions about future
activities with unknown risks. Traditional business models use
discounted cash flow analysis to translate future revenue and cost
streams from a project into todays values. The "best" economic
investment is made by selecting the project with the highest NPV.

Such methodologies have been traditionally used for both public and
private sector sponsored R&D activities. An example of a concise effort
to describe and operationalize a traditional cost-benefit analysis (CBA)
for government sponsored R&D programs is the model initiated by Langford
(1987), extended by Gellman Research Associates (1991a, 1991b, 1991c),
and applied to aeronautical R&D project selection by NASA. With slight
modification, the same model could be applied to other government
agencies. The steps of the Langford model are as follows.

-   Step 1 -- Identification of commercial uses*.* If such uses can be
    identified, the government proceeds to step 2. If no commercial uses
    can be identified, the government omits step 2 and proceeds to step
    3.

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-   Step 2 -- CBA from private sector perspective. If a firm expects a
    positive NPV it will undertake the project; the government does not
    get involved. If all firms expect negative NPV, but still commercial
    uses have been identified in step 1, the government proceeds to step
    3.

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-   Step 3 -- CA from public sector perspective*.* If social NPV is
    negative, the government does not get involved. If social NPV is
    positive (and private NPV negative) the government undertakes the
    project. This calculation must include both the social and private
    benefits, although the latter were not enough to induce private
    firms to go forward with the project.

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-   Step 4 -- Periodic monitoring*.* Periodic reevaluation of the
    project, taking new information as it becomes available into
    consideration, will determine how far along the R&D process the
    government should remain involved. The government remains involved
    until either private NPV turns positive or both private and social
    NPV turn negative.

Financial justification techniques like the above have serious flaws
when it comes to appraising ex ante the desirability of specific
long-term R&D expenditures. First, they assume that a project has only
one outcome; alternative paths that the project may take are not
allowed. Second, they dismiss an extremely important feature of R&D
investments: a strategic, long-term R&D project opens up opportunities
for subsequent investment in a potentially profitable technological
field. Such opportunities would not be available if the initial R&D
investment was never made. There is a significant value to having such
opportunities which is totally missed by conventional CBA models (Newton
and Pearson, 1994). Third, traditional methodologies have tended to use
a constant discount rate into the future \-- essentially assuming that
all forms of risk remain the same five or ten years hence. As a result,
they are heavily biased toward large near-term revenues that almost
automatically makes longer-term R&D projects appear to be bad investment
choices. The bias toward near-term projects is exacerbated during
periods of higher rates of inflation.

This situation is particularly unsatisfactory when it comes to decision
making in the public sector, given the widespread agreement on the
appropriate role of government in civilian science and technology: to
support the creation of knowledge that \"enables\" the R&D activities in
the private sector (Vonortas, 1995). In a country like the United
States, government sponsored R&D is essentially about demonstrating
technological opportunities to enable the private sector make better
investment choices. The failure of available empirical techniques to
have a significant impact on the R&D selection processes in the public
sector may be attributable, at least in part, to their inability to
capture the perceived value of government R&D programs to create such
opportunities for the private sector.

**3. Creating and Exercising Options in Technology Investments**

The very important characteristic of certain R&D investments to create
opportunities to continue or not continue investing in a particular
technological field can now be captured in project appraisal exercises.
Recent advances in economic theory demonstrate that irreversibility,
uncertainty and the choice of timing affect investment decisions in ways
traditional project selection methods omit altogether (Dixit and
Pindyck, 1994). Ex ante appraisals of uncertain R&D programs sponsored
by the public sector provide a natural ground for applying these novel
ideas.

[3.1 Long-term R&D investment as an option]{.underline}

Any useful methodology of investment resource allocation should address
the question: How should a manager (public administrator) facing
uncertainty over future technological and market conditions decide
whether to invest in a new R&D project?

In trying to deal with this question, the NPV approach makes an
implicit, but very strong, assumption. It assumes either that the
investment is reversible -- it can be reversed costlessly should
technological and market conditions prove to be worse than anticipated
-- or that an irreversible investment is undertaken now or never at all.
Unfortunately, R&D investments fall in neither of these categories. On
one hand, R&D investments are largely irreversible: there are
significant costs associated with terminating a project prematurely. On
the other hand, R&D investments can be delayed (rather than be abandoned
altogether). By assuming a fixed scenario with respect to both the
conducting of an R&D project and the generation of cash flows during the
expected lifetime of the projects\' outcome, the NPV methodology largely
misses proper accounting of the contingencies, particularly those
relevant to delaying the project or abandoning it altogether when the
anticipated economic environment proves to have been too optimistic. The
NPV methodology for allocating R&D resources among competing projects
thus needs to be modified to allow decision makers to account properly
for timing, uncertainty and irreversibility. One needs a methodology
allowing for a range of possibilities such as investing now, delay and
perhaps invest next time period, delay and perhaps invest in the period
after next, and so forth. Given that such a methodology would produce a
monetary value on the future investment choice provided by R&D, it would
allow the manager (public administrator) to rank order more efficiently
competing projects and select the most promising for funding.

It has been proposed that there is considerable overlap between "R&D
investment options" and financial options (Dixit and Pindyck, 1994,
1995; Faulkner, 1996; Mitchell and Hamilton, 1988; Newton and Pearson,
1994). In particular, it has been suggested that the decision to invest
initially in an R&D project with an uncertain outcome is conditional on
revisiting the decision sometime in the future. This is similar in its
implications to buying a financial call option. A financial call option
will permit (but not oblige) the owner to purchase stock at a specified
price (exercise price) upon the expiration date agreed in advance. An
initial R&D investment will permit (but not oblige) the investor to
commit to a particular technological area -- thus, buy the entitlement
of the stream of profits from the project -- upon the pre-determined
date for revisiting the initial investment decision. The analogy between
the R&D option and the stock option is summarized as follows:

-   The cost of the initial R&D project is analogous to the price of the
    stock option.

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-   The cost of the future investment needed in order to capitalize on
    the results of the initial R&D project when the investment is made
    is analogous to the exercise price of the stock option.

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-   The (stream of) returns to the investment subsequent to the initial
    R&D project is analogous to the value of the stock for the call
    option.

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-   The downside risk of an initial R&D project is that the overall cost
    of the project will be lost if, for whatever reason, the necessary
    follow-up investments to capitalize on the results are not made.
    This is analogous to the downside risk for a stock option which, in
    the case that the option is not exercised, will be the price of the
    option.

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-   Increased uncertainty decreases the value of an investment (due to
    usually assumed risk aversion). In contrast, increased uncertainty
    -- combined with the possibility of higher returns -- of an initial
    R&D project should increase its value if the project is considered
    as buying an option to a potentially very valuable technology. This
    is analogous to the effect of uncertainty (volatility) on a stock
    option -- volatility in the stock price makes the call option
    valuable (but leaves the downside risk unaffected).

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-   A longer time framework decreases the present discounted value of an
    investment. However, the value of an R&D option may well increase
    with time due to the attraction of longer-term, high-opportunity
    investments compared to investing short-term with limited
    application opportunities. This is analogous to the positive effect
    of time on the value of a financial call option: the further back to
    the future the expiration date of the option, the larger the
    probability of the stock price to exceed a given exercise price.

Thus, when an investor commits to an irreversible investment, he
essentially \"exercises\" his call option. Hence, the question of how to
go about exploiting future opportunities reverts to a question of how to
exercise the corresponding call options optimally (Dixit and Pindyck,
1994). Academics and financial practitioners have studied this problem
of financial call options in stock option pricing theory where the value
of a stock option has been formally expressed as a function of most
parameters involved in options transactions starting with Black and
Scholes (1973) and Merton (1973).

Two points need further clarification. The first point relates to the
observation made earlier that the usefulness of an options approach
draws on the ability to account explicitly for the choice of investing
or not investing in the future. This implies adding something positive
on the benefit side of the cost-benefit analysis relating to a
particular R&D project -- thus increasing the possibility that a project
proves worthy of undertaking although it is rejected on the grounds of a
simple NPV analysis. However, the power of the proposed option approach
also rests with the fact that it can accommodate the value of delaying
an investment. Investments that are not judged worth undertaking now may
become so next time period or the period after next. When the investor
exercises the option, he makes an irreversible investment (\"kills\" the
option). As long as there are some possibilities that the investment
would result in a loss, the opportunity to delay the decision (keeping
the option alive) has value.

The second point relates to the earlier observation concerning the
effect of uncertainty on the value of an investment option. It was said
that the greater the uncertainty over the potential profitability of an
investment, the greater the value of the opportunity and the greater the
value of waiting (keeping the option alive). This should be extended,
however, to reflect the important effects of changes in uncertainty in
this system. A small increase in uncertainty can have two effects. On
the one hand, it can lead managers (including public administrators) to
delay the irreversible investments involving the exercise of the option.
On the other hand, it can induce an acceleration of investments that
create the technological option or that reveal additional information --
that is, the type of investments of interest to the public sector.

[3.2. Using the technology options approach in the public
sector]{.underline}

The prerequisite for understanding the value of future choices is the
perception of research as a process involving successive stages. Each
stage contributes something to the next in terms of both enabling it --
by providing the necessary technical knowledge -- and decreasing the
degree of uncertainty -- by more accurately defining the technical
question to be answered as well as by adding to the available
information concerning the operating environment. It is this latter
feature that makes longer-term research of particular value. The
postulate of broad research stages becomes innocuous when the objective
of the public sector is to enhancing generic technological knowledge
which assists the private sector to speed up the introduction and
commercialization of new or improved products and production techniques.

The option approach to investment can be utilized by government agencies
to select among alternative R&D programs. The task of the public
administrator interested in allocating scarce R&D resources is to
determine whether, by undertaking a proposed R&D program, the government
creates a valuable option to a technology which either it or the private
sector can exercise at some predetermined future date. In making the
go/not go decision at a point in time, the four steps of the
Langford-GRA methodology can be retained, assuming they are modified
appropriately. Vonortas and Hertzfeld (1998) have discussed the
decision-making process in the public sector explicitly, together with a
simple example.

**4. Concluding Remarks**

R&D managers in the private sector and public administrators have always
described the merits of long-term research on the grounds of its
inherent value for opening up opportunities for future investment in new
technological areas with potentially substantial returns. It is only
recently, however, that the foundations of a methodology capable of
capturing the practitioner's intuition have been formulated. The
beginnings of this methodology can be traced to a branch of finance
theory which, during the last couple of decades, has developed measures
of the intrinsic value of stock options. It turns out that the basic
idea can be applied to \"real investments\" characterized by
irreversibility and high uncertainty. Long-term, strategic R&D is such
an investment.

Perceiving R&D as a multi-stage process could also facilitate the
transition away from using inappropriate discount rates for future
expected returns. By using a single discount rate into the future,
traditional methodologies essentially assume that risk remains unchanged
(it is simply compounded) during the course of a long-term R&D program.
The technical connotation of unvarying discount rates is that the risks
associated with future cash flow estimates are increasing geometrically
with chronological distance from the present.

This is, of course, a simplistic approach to the evaluation of risk. A
long-term R&D project is a somewhat unique type of investment. A classic
case seems to be that of research, engineering, prototype production and
testing. All these stages provide information about the ultimate cost of
production and about potential market conditions. Each investment stage
yields information that reduces the uncertainty over the value of the
completed project. The fact that uncertainty decreases in consecutive
stages due to information gathering should be reflected in differing
discount factors for each stage.

Ideally, different industries, different technologies, and different R&D
programs should be assigned different discount rates. If the ideal is
too much to ask, a middle ground solution could be found in [assigning
different discount factors to different stages of an R&D program while
using an options approach to program evaluation and selection. The
incorporation of such changes in government R&D selection methodologies
would constitute an important step in facilitating the process of
choosing the best among competing R&D investments characterized by
irreversibility, uncertain outcomes and long time periods to fruition.
It would also make the selection process more realistic.]{.underline}

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[^1]: \* This paper draws extensively on Nicholas S. Vonortas and Henry
    R. Hertzfeld (1998) R&D Project Selection in the Public Sector,
    [Journal of Policy Analysis and Management]{.underline}, 17(4):
    621-638.