Management of Technology 8
Chaisung Lim, Miller School of MOT edisonfoot@gmail.com 1

Overview
‹Methods of choosing innovation projects range from informal to highly structured, and from entirely qualitative to strictly quantitative. ‹Often firms use a combination of method to more completely evaluate the potential (and risk) of an innovation project.

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The Development Budget
‹Most firms face serious constraints in capital and other resources they can invest in projects.
‹Firms thus often use capital rationing: they set a fixed R&D budget and rank order projects to support.
™R&D budget is often a percentage of previous year’s sales. ™Percentage is typically determined through industry benchmarking, or historical benchmarking of firm’s performance. 3

The Development Budget
‹R&D Intensity varies considerably across and within industries. 4

Theory in Action
Financing New Technology Ventures
™Large firms can fund innovation internally; new start-ups must often obtain external financing.
™In first stages of start-up and growth, entrepreneurs may have to rely on family, friends, and credit cards.
™Start-ups might be able to obtain some funding from government grants and loans.
™If idea and management are especially promising, entrepreneur may secure funds from “angel investors”
(typically seed stage and <$1 million) or venture capitalists (multiple early stages, >$1 million).

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Quantitative Methods for Choosing Projects

‹Most commonly used quantitative methods include discounted cash flow methods and real options.
™Discounted Cash Flow (DCF)
- Net Present Value (NPV): Expected cash inflows are discounted and compared to outlays.

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Quantitative Methods for Choosing Projects

- Internal Rate of Return (IRR): The discount rate that makes the net present value of investment zero.
- Calculators and computers perform by trial and error.
- Potential for multiple IRR if cash flows vary

™Strengths and Weaknesses of DCF Methods:
- Strengths
- Provide concrete financial estimates
- Explicitly consider timing of investment and time value of money

- Weaknesses
- May be deceptive; only as accurate as original estimates of cash flows. - May fail to capture strategic importance of project

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Quantitative Methods for Choosing Projects

™Real Options: Applies stock option model to nonfinancial resource investments. E.g.,with respect to R&D:
- The cost of the R&D program can be considered the price of a call option.
- The cost of future investment required to capitalize on the
R&D program (such as the cost of commercializing a new technology that is developed) can be considered the exercise price. - The returns to the R&D investment are analogous to the value of a stock purchased with a call option.

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Quantitative Methods for Choosing Projects
Examples of real call options:

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Quantitative Methods for Choosing Projects

‹Options are valuable when there is uncertainty (as in innovation)
‹However, real options models have some limitations: ™Many innovation projects do not conform to the same capital market assumptions underlying option models.
- May not be able to acquire option at small price: may require full investment before its known whether technology will be successful. - Value of stock option is independent of call holder’s behavior, but value of R&D investment is shaped by the firm’s capabilities, complementary assets, and strategies.

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Qualitative Methods of Choosing Projects

‹Many factors in the choice of development projects are extremely difficult (or misleading) to quantify.
‹Almost all firms thus use some qualitative methods. ™Screening Questions may be used to assess different dimensions of the project decision including:
- Role of customer (market, use, compatibility and ease of use, distribution and pricing)
- Role of capabilities (existing capabilities, competitors’ capabilities, future capabilities)
- Project timing and cost

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Qualitative Methods of Choosing Projects
™Mapping the Company’s R&D