Real option valuation of public sector R&D investments with a down-and-out barrier option

This paper presents a real options approach for valuing public-sector research and development projects, using a down-and-out barrier option. Specifically, it considers the potential savings to the tax payer for investing in technology to be purchased by a national government. The valuation is performed with stretched trinomial lattices. Government-driven demand for this technology is equated with the underlying asset, and valuation measured in terms of potential government savings. Two variables, volatility of demand for the technology and unit cost, are treated as uncertain. A Monte Carlo simulation is performed to understand the effects of these variables on the valuation. Other variables are estimated, and a parametric analysis is performed to understand the effects of these variables. To illustrate how this approach could be used, the development of a new sensor, to be used in large networks that track greenhouse gas fluxes, is considered as an example.