Choosing Innovation Projects

8 important questions on Choosing Innovation Projects

What is meant with capital rationing?

The firm sets a fixed research and development budget and then uses a rank ordering of possible projects to determine which will be funded.

How is the rank ordering established for capital rationing?

By any number of methods, including quantitative methods, such as discounted cash flow analysis or options analysis, or qualitative methods, such as screening questions and portfolio mapping, or a combination of multiple methods.

What are 2 quantitative discounted cash flow methods?

- Net present value (NPV), the discounted cash inflows of a project minus the discounted cash outflows
- Internal rate of Return (IRR), the rate of return yielded by a project, normally calculated as the discount rate that makes the net present value of an investment equal zero.
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When do you make use of a real option?

When a firm invests in new core technologies it also invests in new capabilities. Therefore development can create value for the future firm which would be otherwise unavailable. So even expensive investments which seem to be not valuable on first sight can create options for the future of the firm. Therefore real options are currently often used. A real option is the application of stock option valuation methods to investments in nonfinancial assets.

How does the real options looks like, in terms of costs, future investment and returns?

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.

What is the most common method for choosing a project?

Qualitative methods, because many factors are difficult to quantify.

An method for using both methods is Data Envelopment analysis, what is it?

A method of ranking projects based on multiple decision criteria by comparing them to a hypothetical efficiency frontier.

What is the biggest advantage of using DEA (Data Envelopment Analysis)?

It enables comparisons of projects using multiple kinds of measures.

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