Real option approach applied by ABB

Summary form only given. Real options is a new method, derived from financial theory, to evaluate R&D-projects. This new method leads to more defensible valuations and allows insights for the value-based management of technology-intensive companies. ETH Zurich and ABB Corporate jointly developed a real options-based model which incorporates the managerial flexibility and the risks of R&D-projects. Building on the theory of real options, this industry application shows how the model itself is realized and used for the valuation of R&D-projects. The main problem of using real options is, on the one hand, to understand the mathematical formulas, and on the other hand, real option methods require more input data, such as time to option expiry, uncertainty of expected cash flow, or value lost over option duration. After testing this various state-of-the-art valuation methods, ABB decided to apply Monte Carlo simulation. This approach provides the most comprehensive insight of all valuation methods