In this thesis a new valuation method is applied to the research and development (R&D), the use of options approach, which permits a more flexible assessment of the future growth opportunities in the entire process. The traditional DCF method when naively applied fails to capture all the future opportunities that create value, thereby resulting in an underinvestment in R&D. The options approach is more appropriate in a world of uncertainty because it views an R&D project as an initial investment that creates future follow-on commercial opportunities that are undertaken only if the initial R&D project is successful.
The advent of options pricing methodology and its application to investment opportunities allows firms to value downstream alternatives that may become available. In this thesis a valuation model that incorporates the risk-free arbitrage features of the binomial option pricing model into the decision tree framework is applied to the research and development. The model is applied to the new R&D project of a venture company to illustrate how one can use the option approach rather than the conventional DCF method to value an R&D investment involving the introduction of a new product. In addition, the valuation method shows how R&D project can be linked to a company’s stock price to make more meaningful economic decision to investors.