The application of real options theory in defense R&D projects: An eight-fold sequential compound option model

Today, despite the needs of more credible valuation models in defense research and development (R&D), defense decision makers mainly focus on previous cost and NPV-based approaches to evaluate them. Defense R&D projects should be considered as a sequential compound real option due to its relevant characteristics. This paper presents a real option valuation model with the use of an eight-fold compound option in the valuation of defense R&D projects and its illustrative application using a case study in the Republic of Korea. Compared to the traditional net present value (NPV) methods and their sensitivity analyses with value drivers, the paper shows the necessity of using real option approaches and their mindsets for defense decision makers to decide their defense R&D projects. The contribution of this paper is to present the real option framework in valuating of defense R&D projects, providing for the managerial flexibility with option mindsets. It also shows some limitations of using cost- and NPV-based approaches and presents real options valuation methods as its solution. The paper suggests some feasible defense policy implications that can be applied to the actual process of defense acquisition projects.