A SYSTEMS APPROACH TO R&D INVESTMENT NG CHU NGAH NATIONAL UNIVERSITY OF SINGAPORE 2007 A SYSTEMS APPROACH TO R&D INVESTMENT NG CHU NGAH B.Eng.(Hons.), NUS A THESIS SUBMITTED FOR THE DEGREE OF MASTERS OF ENGINEERING DEPARTMENT OF INDUSTRIAL AND SYSTEMS ENGINEERING NATIONAL UNIVERSITY OF SINGAPORE Summary R&D activities are increasingly recognised as the engine for corporate growth, yet they remain a challenge when it comes to valuation and selection. R&D projects carry huge risks which make the potential high payoffs illusive, but these payoffs are precisely the incentive for the examination of project selection methodologies. While there is no hard and fast rule to compare and select R&D projects, this report aims to propose possible improvements to the selection and management process. Our work builds on the concept of the strategy-monetary division of the Organisational Decision Support System (ODSS) and customises it into three segments: (1) ONline R&D focus selection (2) OFFline project valuation, and (3) ONline portfolio selection. At the online level, Real Options (ROs) thinking is incorporated to specifically deal with the option to defer and its tradeoff of gaining competitive advantage. We reason that this RO should make sense only if considered at the strategic level because of the existence of tradeoffs. Zeroing in on the individual projects at the offline stage, we separate risks and payoffs with a new perspective—the “within firm” and “beyond firm” distinction. Decision Analysis (DA) is then brought in for the modelling of sequential decisions. Since real i Summary projects are not as flexible as financial options when it comes to opportunities to exit, decision trees are sufficient in capturing the option to abandon. However, DA also has its shortcomings. It depends largely on subjective expert opinions, and these are costly to obtain yet not reliable particularly at project outset as studies have shown. Nonetheless, judgemental methods are unavoidable for R&D projects due to decreased liquidity (Drzik, 1996). We thus propose the borrowing of financial market data to replace, or at least complement, the subjective probabilities used in DA, especially at the initial project selection stage. This recommendation relies on the assumption that the eventual value of R&D projects would be reflected in the shareholder returns in financial markets, following the launch of the new products or technologies. Our scope is hence limited to five industries as identified by Foster and Kaplan (2001), where there appear to be a positive correlation between R&D investment and shareholder return. They are namely pharmaceutical, pulp and paper, commodity and specialty chemicals, aerospace and defence, as well as oil extraction. For the treatment of the data, we extend the idea of collapsing the leaf-values into biextremal values using the simplification rule, and adopted a suitable common financial risk measure—the Value at Risk (VaR). However, VaR has, in recent years, been discredited as an incoherent risk measure (Artzner et al., 1999). A similar risk measure called the Expected Tail Loss (ETL)—the expectation of losses beyond VaR—turned out to be a possible remedy. The purpose of both is the same and the calculation of ii Summary ETL an extension from VaR. Hence, we continue the use of VaR but note that the subsequent discussion makes reference to both. VaR and ETL are boundary quantiles and should provide more information be it for initial project selection or ongoing budget control: the point to exercise the option to abandon becomes more guided. Comparing VaR with simulation, we note that VaR is like integrating real options into simulation. As pointed out by scholars, simulation is useful but probably the extent of usefulness is limited to the central 80% of the information due to the consideration of options and management flexibility. Thus, the interval between the VaRs allows us to focus on the essential information. On the technical side, the recent use of Extreme Value Distributions (EVDs) and Generalised Pareto Distributions (GPDs) to approximate VaRs is appealing in our study as they would allow direct simulation of the boundary quantiles. Our results show that the GPD method is preferred over the parametric method for both the upper and lower-bound VaR. This method would thus enable us to calculate a baseline for the payoff/loss estimation, while allowing decision makers to see the maximum potential of particular projects, thereby setting an investment limit before abandonment should be exercised. iii Acknowledgement This thesis extends my B.Eng honours project. Along the entire journey, I am grateful to many people around me for their help, guidance, encouragement, and concern. First and foremost, I would like to express my sincere appreciation for my mentor, A/P Poh Kim Leng, who is always so patient and willing to take time off his hectic schedule to give me invaluable advice—work or non-work related alike—and to explain concepts foreign to me. I thank him also for granting me the freedom and independence to explore possible research areas which I have interest in. Having such a supportive supervisor is indeed a blessing. Secondly, my heartfelt gratitude also goes to my internship supervisor, Mr. See Chuen Teck, for his inputs and tips. Equipped with practical experience and industrial knowledge, he is a great source of information and ideas. Indeed, a discussion with him beats all blind research. Thirdly, a special mention and acknowledgement for Dr. François Longin who had guided me through my first research training at ESSEC Business School in France in the year 2004. This invaluable experience gave me a peek into the vast world of Finance, and introduced me to the concept of Value-at Risk which serves as one of the preliminary sources of inspiration for this thesis. iv Acknowledgement In addition, I would also like to express my appreciation to the department and the university for giving me the chance to fulfill my third and fourth year of my undergraduate studies at the Ecole Nationale des Ponts et Chaussées (ENPC) in France, as well as the opportunity to present my work at the Asia Pacific Industrial Engineering Management (APIEMS) conference 2006 at Bangkok. The various programs and experiences have been highly enriching. On this note, my sincere thanks also go to DSTA who supported and financed my studies in France and a return trip for the presentation of my internship at DSTA which required my return to ENPC during my research period; as well as the NUS Graduate Office for coordinating my return to the department. Finally, I dedicate this thesis as a gesture of thanks to my parents and brothers for their unyielding support and advice; to my friends particularly Zhili and Zhiyun for their concern for my progress and adaptation back to the NUS culture; and to my lab-mates who helped make my integration into the community a smooth and pleasant one. v Table of Contents Summary ______________________________________________________ i Acknowledgement ______________________________________________ iv Table of Contents ______________________________________________ vi Terms and Abbreviations _________________________________________ ix List of Figures _________________________________________________ x List of Tables __________________________________________________xii Chapter Introduction . 1.1 Motivation—Real Options ______________________________________ 1.2 Proposed Improvements _______________________________________ 1.3 Organisation of Thesis_________________________________________ Chapter R&D Projects . 2.1 Benefits of R&D ______________________________________________ 2.2 R&D Landscape _____________________________________________ 2.3 General Considerations_______________________________________ 11 2.4 R&D Project Lifecycle ________________________________________ 12 2.5 R&D Project Risks ___________________________________________ 14 2.6 Conclusion_________________________________________________ 16 Chapter R&D Project Valuation Tools 17 3.1 Discounted Cash Flow________________________________________ 17 3.2 Decision Analysis ___________________________________________ 19 3.3 Simulation _________________________________________________ 23 3.4 Real Options Approach _______________________________________ 24 3.5 Conclusion_________________________________________________ 30 Chapter R&D Project Selection Cycle and ODSS 31 4.1 Offline: Individual Project Analysis ______________________________ 32 4.2 Online: R&D Capital Allocation _________________________________ 37 4.3 Conclusion_________________________________________________ 40 vi Table of Contents Chapter Framework . 41 5.1 A novel view of the R&D Project Lifecycle_________________________ 41 5.2 Project Selection: ODSS modified_______________________________ 42 5.3 Project Management: Online Decisions __________________________ 47 5.4 Consolidated framework ______________________________________ 49 Chapter Offline Project Valuation Considerations 50 6.1 Role of Real Options _________________________________________ 50 6.2 Inconveniences of DA ________________________________________ 51 6.3 Assumption ________________________________________________ 53 6.4 Risk Measure: Value-at-Risk (VaR)______________________________ 55 Chapter Value-at-Risk (VaR) 61 7.1 Calculation of the VaR by the Historic Method _____________________ 61 7.2 Calculation of the VaR by the Parametric Method___________________ 62 7.3 Calculation of the VaR by the Classical EV Method _________________ 63 7.4 Calculation of the VaR by the Modern EV Method __________________ 70 7.5 How VaR Adds Value ________________________________________ 73 Chapter Case Example: 40 stocks from the NYSE 74 8.1 Context ___________________________________________________ 74 8.2 Historic Approach ___________________________________________ 78 8.3 Parametric – Normal _________________________________________ 78 8.4 GEV Approach _____________________________________________ 79 8.5 GPD Approach _____________________________________________ 85 8.6 Conclusion_________________________________________________ 90 Chapter Conclusion and Future Work 91 9.1 Implications of Findings _______________________________________ 91 9.2 Limitations _________________________________________________ 92 9.3 Future Work________________________________________________ 93 9.4 Final note__________________________________________________ 94 List of References 96 vii Table of Contents Appendix A Financial Option Pricing 101 A.1 Option Pricing Models - Samuelson (1965)_______________________ 101 A.2 Option Pricing Models - Black-Scholes model (1973) _______________ 101 A.3 Option Pricing Models – Merton (1973)__________________________ 107 A.4 Option Pricing Models - Cox, Ross, & Rubinstein (1979) ____________ 108 Appendix B Fitting Extreme Value Distributions 116 B.1 Parameter Estimation by Maximum likelihood Method ______________ 116 B.2 Standard Error _____________________________________________ 118 Appendix C Calculating VaR using BestFit data 120 C.1 Gumbel __________________________________________________ 120 C.2 Weibull___________________________________________________ 121 Appendix D P-P plots for GEV and GPD fitting . 122 Appendix E * Companies selected for study 134 E.1 Medical Laboratories and Pharmaceuticals_______________________ 134 E.2 Pulp and Paper ____________________________________________ 138 E.3 Commodity and Specialty Chemicals ___________________________ 141 E.4 Aerospace and Defence _____________________________________ 144 E.5 Oil Extraction ______________________________________________ 147 Appendix F Results from Case Study –VaR Max . 149 Appendix G Results from Case Study –VaR Min 152 viii Appendix E * Companies selected for study 2.4 Longview Fibre Co. http://www.longviewfibre.com Founded in 1926 and is headquartered in Longview, Washington, Longview Fibre Company offers forest, paper, and packaging products in the United States. It manufactures corrugated and solid-fiber containers, handle shopping and merchandise bags, and other paper products. The company operates in three segments: Timber, Paper and Paperboard, and Converted Products. 2.5 Mercer International Inc. http://www.mercerinternational.com Mercer International, Inc. and its subsidiaries enter the pulp and paper industry in 1993. It offers northern bleached softwood kraft (NBSK) pulp, kraft pulp, and market pulp in Germany. 2.6 Nashua Corp. http://www.nashua.com/ Nashua Corporation engages in the manufacture and marketing of labels, specialty papers, and imaging products in the United States. The company operates in three segments: Label Products, Specialty Paper, and Imaging Supplies. 2.7 Neenah Paper Inc. http://www.neenah.com Spun off from Kimberly-Clark in 1994, Neenah Paper, Inc. engages in the manufacture and distribution of premium and specialty paper grades, as well as bleached kraft pulp in North America and Europe. The company has three primary operations: the fine paper business, the technical paper business, and the pulp business. 139 Appendix E * Companies selected for study 2.8 PH Glatfelter Co. http://www.glatfelter.com Glatfelter is one of the world's leading manufacturers of specialty papers and engineered products. Started by Philip H. Glatfelter in 1864 as a newsprint manufacturer, the company has evolved and grown dramatically through the years. 140 Appendix E * Companies selected for study E.3 3.1 Commodity and Specialty Chemicals Aceto Corp. http://www.aceto.com Aceto Corporation engages in the marketing, sale, and distribution of pharmaceutical, biopharmaceutical, specialty, and industrial chemicals used primarily in the agricultural, colour producing, pharmaceutical, nutraceutical, and surface coating industries worldwide. It operates in three segments: Health Sciences, Chemicals and Colorants, and Agrochemicals. 3.2 Air Products & Chemicals Inc. http://www.airproducts.com Air Products and Chemicals, Inc. operates in the industrial gas and related industrial process equipment business worldwide. The company operates through three segments: Gases, Chemicals, and Equipment. Air Products was established in 1940 in Detroit, Michigan, on the strength of a simple, but then revolutionary, idea: the "on-site" concept of producing and selling industrial gases, primarily oxygen. At the time, most oxygen was sold as a highly compressed gas product in cylinders that weighed five times more than the gas itself. Air Products proposed building oxygen gas generating facilities adjacent to large-volume users, thereby reducing distribution costs. The concept of piping the gas directly from the generator to the point of use proved sound and technically solvable. 141 Appendix E * Companies selected for study 3.3 CIBA Specialty Chemicals Holding, Inc. http://www.cibasc.com Incorporated in 1996 and headquartered in Basel, Switzerland, Ciba Specialty Chemicals Holding, Inc. engages in the development and production of specialty chemicals. The company operates in four segments: Plastic Additives, Coating Effects, Water and Paper Treatment, and Textile Effects. 3.4 FMC Corp. http://www.fmc.com FMC Corporation operates as a chemical company, serving the agricultural, industrial, and consumer markets worldwide. The company operates in three segments: Agricultural Products, Specialty Chemicals, and Industrial Chemicals. 3.5 General Chemical Industrial Products Inc. http://www.genchem.com General Chemical Industrial Products, Inc. produces soda ash and calcium chloride in North America. Formed in 1999, it is now the second largest soda ash producer in North America and the fifth largest globally, as well as the second largest producer of calcium chloride in North America. 3.6 Lyondell Chemical Co. http://www.lyondell.com Lyondell Chemical Company engages in the manufacture and marketing of various intermediate and performance chemicals. It operates through four segments: ethylene, co-products, and derivatives; propylene oxide and related products; inorganic chemicals; and refining. 142 Appendix E * Companies selected for study 3.7 Praxair Inc. http://www.praxair.com Praxair, Inc. operates as an industrial gas company that supplies atmospheric, process and specialty gases, high-performance coatings, and related services and technologies in North and South America, Europe, and Asia. Its primary products are atmospheric gases and process and specialty gases. 3.8 Rohm & Haas Co. http://www.rohmhaas.com Rohm and Haas Company (RHC) provides specialty materials for the personal care, grocery, home, and construction markets in the United States. It operates in six segments: Coatings, Performance Chemicals, Monomers, Electronic Materials, Adhesives and Sealants, and Salt. 143 Appendix E * Companies selected for study E.4 4.1 Aerospace and Defence Boeing Co. http://www.boeing.com The Boeing Company operates in the aerospace industry worldwide. It has four segments: Commercial Airplanes, Integrated Defense Systems (IDS), Boeing Capital Corporation (BCC), and Other. 4.2 DRS Technologies Inc. http://www.drs.com DRS Technologies, Inc. supplies defense electronic products and systems. The company operates in two segments, the Command, Control, Communications, Computers, and Intelligence (C4I); and the Surveillance and Reconnaissance (SR). DRS relies on US government agencies (primarily the DoD) for more than 80% of sales. 4.3 Goodrich Corp. http://www.goodrich.com Goodrich Corporation supplies components, systems, and services to the commercial, regional, business, and general aviation markets worldwide. It operates in three segments: Airframe Systems, Engine Systems, and Electronic Systems. 4.4 Lockheed Martin Corp. http://www.lockheedmartin.com Lockheed Martin Corporation, an advanced technology company, was formed in March 1995 with the merger of two of the world's premier technology companies, 144 Appendix E * Companies selected for study Lockheed Corporation and Martin Marietta Corporation. Lockheed Martin Corporation engages in the research, design, development, manufacture, integration, operation, and support of technology systems, products, and services in the United States and internationally. 4.5 Mooney Aerospace Group Ltd. http://mooney.com/ Mooney Aerospace Group, Ltd., through its wholly owned subsidiary, Mooney Airplane Company, engages in the design and manufacture of four-place, singleengine, and retractable gear aircraft in the United States. Mooney Aerospace Group was formed in 1990 and emerged from bankruptcy in December 2004. 4.6 Pemco Aviation Group Inc. http://www.pemcoair.com Pemco Aviation Group, Inc., a diversified aerospace and defense company, provides aircraft maintenance and modification services, including complete airframe inspection, maintenance, and repair and custom airframe design and modification in the United States. It operates through three segments: Government Services, Commercial Services, and Manufacturing and Components. The US government accounts for about twothirds of Pemco's sales. 4.7 Raytheon Co. http://www.raytheon.com Raytheon Company provides defense and government electronics, technical services, and aircraft worldwide. The US government (including foreign military sales) accounts for nearly three-quarters of sales. 145 Appendix E * Companies selected for study 4.8 Rockwell Collins Inc. http://www.rockwellcollins.com Rockwell Collins, Inc. engages in the design, production, and support of communications and aviation electronics for military and commercial customers worldwide. The company operates through two segments, Government Systems and Commercial Systems. 146 Appendix E * Companies selected for study E.5 5.1 Oil Extraction EnerNorth Industries Inc. http://www.epsx.com EnerNorth Industries, Inc. engages in the investment in, and exploration, development, and production of oil and gas. 5.2 Globalsantafe Corp. http://www.gsfdrill.com GlobalSantaFe Corporation operates as an offshore oil and gas drilling company. The company provides oil and gas contract drilling services to the oil and gas industry worldwide on a daily rate basis. 5.3 Ivanhoe Energy Inc. http://www.ivanhoe-energy.com/s/Home.asp Ivanhoe Energy is an independent international oil and gas exploration and development company building long-term growth in its reserve base and production. Core operations are in the US and in China. 5.4 Miller Petroleum Inc. http://www.millerpetroleum.com Miller Petroleum, Inc. engages in the exploration, development, production, and acquisition of crude oil and natural gas in Appalachian region of eastern Tennessee and in the state of Texas. 147 Appendix E * Companies selected for study 5.5 Ness Energy International Inc. http://www.nessenergy.com Ness Energy International, Inc. engages in the acquisition, development, exploitation, and exploration of oil and gas properties, and in the production, marketing, and transportation of oil and natural gas both in Israel and the United States. 5.6 Petroleo Brasileiro. http://www.petrobras.com.br Petroleo Brasileiro S.A. - Petrobras engages in a range of oil and gas activities. It operates in four segments: Exploration and Production (Exploration and Development); Refining, Transportation, and Marketing (Supply); Distribution; and Natural Gas and Power (Gas and Energy). 5.7 Transocean Inc. http://www.deepwater.com Transocean, Inc. provides offshore contract drilling services for oil and gas wells. It contracts drilling rigs and related equipment, and work crews to drill oil and gas wells. The company also provides integrated services. It operates through two segments, Transocean Drilling and TODCO. 5.8 United Heritage Corporation. http://www.unitedheritagecorp.com/ United Heritage Corporation, through its subsidiaries, engages in the exploration and production of natural gas and crude oil. 148 Appendix F Results from Case Study – VaR max Appendix F Results from Case Study –VaR Max 149 Appendix F Results from Case Study – VaR max 150 Appendix F Results from Case Study – VaR max 151 Appendix G Results from Case Study – VaR Appendix G Results from Case Study –VaR Min 152 Appendix G Results from Case Study – VaR 153 Appendix G Results from Case Study – VaR 154 [...]... selection and finally to management Next, we shall then focus on the offline stage for the alternative treatment of individual project valuation Chapter 6 explains all the considerations taken into account Chapter 7 dives into the various approaches to calculate the financial risk measure, VaR Chapter 8 gives a case example showing the calculation of VaRs from the New York Stock Exchange, as well as a discussion... approaches Table 1-2: Benefits of the VaR approach Traditional approaches How VaR value-add Calculate Expected Value of individual Use VaR to identify interval of possible projects (NPV, DA, RO) for comparison returns and thus capture volatility DA depends solely on expert opinions Financial data as captured by VaR as an objective complement Simulation to take into account fuller risk VaR need not assume a return... Introduction Table 1-1 summarises the tools and context at the traditional level, as well as the proposed amelioration and paradigm shifts Table 1-1: Critical review of traditional approaches Traditional approaches Paradigm shift & Improvements Tools – Real Options - - the concept of risk neutrality can be - Real options are not financial options, applied to take care of choice of thus the assumptions not applicable... definite way to compare and select R&D projects which essentially carry huge uncertainty It is also not clear how the uncertainty should be managed, particularly how to decide whether to abandon the project to prevent huge losses The purpose of this work is thus to propose an overall selection and management framework that incorporates various tools and ideas, yet remaining logical and easy to understand... observation by Cooper (1999) that the best companies use several complementary methods at the same time 1 Chapter 1 Introduction 1.1 Motivation—Real Options The Real Options (RO) approach is theoretically attractive with its lofty ambition to give a numerical value to management flexibility Unfortunately, it is mathematically complex as fundamental issues like volatility remain unresolved; and arguably... (GPD) approach is preferred over the parametric method for both the upper and lower bound VaR This method would thus enable us to calculate a baseline for the loss estimation, while allowing decision makers to see the maximum potential of particular projects, thereby setting an investment limit before abandonment should be exercised Table 1-2 summarises the advantages of VaR over the traditional approaches... industries like pharmaceutical, pulp and paper, commodity and specialty chemicals, aerospace and defence, as well as oil extraction, it appears that the companies which concentrate on sustained growth through investment in R&D are most likely to achieve increased shareholder return 1 (Foster and Kaplan, 2001) R&D results in valuable inventions, ideas and designs which can be sources of potential value when... companies in the world by market capitalisation As can be inferred from the table, the US is strongly represented in the three big R&D-intensive industry sectors: pharmaceuticals, IT hardware and software In contrast, Europe is relatively weak in IT and related fields, while Asia lacks a vibrant pharmaceutical sector It should be noted that an R&D intensity of over 15% is considered remarkable and... innovation, which involves the introduction of a new good or service that has been substantially improved According to Foster and Kaplan (2001), innovation can be classified in increasing impact of wealth creation and newness as incremental, substantial or transformational (c.f Figure 2-1) Different level of innovation requires a different managerial treatment In our study, we are interested in the latter... time, makes valuation elusive Since only the investment costs are certain, a risk-averse valuation would tend to produce negative net present values and thus discourage calculated risk-taking 3.1 Discounted Cash Flow Traditionally, the Discounted Cash Flow (DCF) method is used to evaluate the attractiveness of an investment opportunity by estimating the value of the project, and this tool can also be . summarises the advantages of VaR over the traditional approaches. Table 1-2: Benefits of the VaR approach Traditional approaches How VaR value-add Calculate Expected Value of individual projects. at the traditional level, as well as the proposed amelioration and paradigm shifts. Table 1-1: Critical review of traditional approaches Traditional approaches Paradigm shift & Improvements. correlation between R&D investment and shareholder return. They are namely pharmaceutical, pulp and paper, commodity and specialty chemicals, aerospace and defence, as well as oil extraction.