Unlocking the value of real options: How firm‐specific learning conditions affect R&D investments under uncertainty

• Author: Emanuel Varga,Jan H. Fisch,Jan‐Michael Ross
• Published date: 01 September 2018
• DOI: http://doi.org/10.1002/sej.1275
• Date: 01 September 2018

RESEARCH ARTICLE

Unlocking the value of real options: How firm-

specific learning conditions affect R&D

investments under uncertainty

Jan-Michael Ross

1

| Jan H. Fisch

2,3

| Emanuel Varga

4

1

Management Department, Imperial College

Business School, Imperial College London,

London, U.K.

2

Department of Global Business and Trade,

Vienna University of Economics and Business,

Vienna, Austria

3

Newcastle Business School, University of

Newcastle, Callaghan, New South Wales,

Australia

4

BMW Group, Munich, Germany

Correspondence

Jan H. Fisch, Vienna University of Economics

and Business, Welthandelsplatz 1,

Building D1,1020 Vienna, Austria.

Email: jan.fisch@wu.ac.at

Research Summary: Why do some firms increase R&D invest-

ments in the face of uncertainty, while others do not? Contrary to

common wisdom, this study posits that uncertainty prompts firms

to invest in R&D. The value to invest under uncertainty is, how-

ever, bounded by a firm's learning conditions (i.e., human capital,

relatedness of innovation activities, and industry maturity). An

empirical test on a cross-industry panel of 551 business divisions

of manufacturing firms reveals how organization-environment

interactions determine the firm-specific value to invest in learning

prior to full-scale commercialization. The insights help to bridge

real options theory and the learning literature.

Managerial Summary: Uncertainty about the market environment

makes investment decisions in R&D and the commercialization of

new products a challenge: should firms “wait and see”until uncer-

tainty resolves to avoid the risk of betting on the wrong product

or commit further resources regardless? Our analysis suggests that

manufacturing firms often take a mixed approach (“act and see”).

While deferring investments in the commercialization of new

products, they undertake further R&D to inform decision making

by insights that would otherwise be unavailable. However, we find

that the benefit of such practice depends on the learning condi-

tions of the individual firm. What is risky for firms with disadvan-

tages in human capital and technology development is value

enhancing for firms with good foundations for learning

through R&D.

KEYWORDS

learning, investments, total uncertainty, R&D, real options

Received: 28 April 2011 Revised: 4 August 2017 Accepted: 20 August 2017 Published on: 16 October 2017

DOI: 10.1002/sej.1275

Copyright © 2017 Strategic Management Society

Strategic Entrepreneurship Journal. 2018;12:335–353. wileyonlinelibrary.com/journal/sej 335

1|INTRODUCTION

Firm differences in allocating resources to research and development (R&D) activities have long captured the inter-

est of organizational theorists and strategic management scholars (e.g., Cuervo-Cazurra & Un, 2010; Greve, 2003;

Helfat, 1994a, 1994b). Seminal studies emphasize the path-dependent nature of search processes that can cause

persistence in R&D spending (Nelson & Winter, 1982) and stability in R&D intensity over time (Chen & Miller,

2007). Patel and Pavitt (1997), however, observe that a considerable variance of resources allocated to R&D is

unexplained and suggest that this relates to firm-specific managerial decisions made under uncertainty. Those deci-

sions can serve a critical role in attaining entrepreneurial rents, which are the rewards for being prepared to act in

the face of uncertainty (Knight, 1921; Rumelt, 1987).

Empirical studies find that dynamically adjusting R&D investments to the level of uncertainty generates value

(Levitas & Chi, 2010; Oriani & Sobrero, 2008). The underlying theory predicts a negative effect of demand uncer-

tainty on investment (Dixit & Pindyck, 1994; McDonald & Siegel, 1986) and assumes that firms from the same

industry react to changing market conditions in similar ways. However, recent work finds a positive relationship

between uncertainty and R&D investments (Bromiley, Rau, & Zhang, 2017) and emphasizes the role of firm hetero-

geneities in valuing and capitalizing on uncertain opportunities (Klingebiel, 2012; Trigeorgis & Reuer, 2017), suggest-

ing so far neglected sources of heterogeneity in explaining R&D investments. This spurs the question: Why do some

firms increase R&D investments in the face of uncertainty, while others do not?

The literature on resource allocation decisions in the field of strategy and organization has largely built on the

assumption that uncertainty can be resolved by undertaking R&D (e.g., Cohen & Levinthal, 1994) or negotiating with

the environment (Cyert & March, 1963). However, firms also face uncertainties that are largely unaffected by their

actions and may resolve over time (Folta, 1998). Consequently, as firms of an industry often operate in the same

market environment but have different abilities to learn about their risks, they differ in relative sources of uncer-

tainty. It is this total uncertainty (including both unsystematic and systematic components) that managers worry

about and act on (Amram & Kulatilaka, 1999). Hence, the combined effect of firm-specific learning abilities and

industry-wide uncertainty is pertinent to managerial valuation of investment decisions and could be a source of het-

erogeneity in R&D investments across firms.

Building on the real options literature, we study resource allocation to R&D activities as learning investments

that yield information on superior ways of combining organizational and technological elements to exploit uncertain

market opportunities (Amram & Kulatilaka, 1999; Brown & Eisenhardt, 1998; Kogut & Kulatilaka, 2001). We posit

that while uncertainty about current market demand lowers investment in the production of new products, it moti-

vates firms to undertake further R&D activities, as the latter can reduce earnings surprises and facilitate informed

decision making unavailable to others who wait. Furthermore, we argue that the value to invest in learning is firm

specific because the expected outcomes are bounded by the firm's learning conditions, which are determined by its

human capital, relatedness of innovation activities, and industry maturity.

Using a cross-industry panel of 551 business divisions of manufacturing firms, we find support for our argu-

ments. The insights from the study contribute to the literature in important ways. First, we advance the literature

on real options by providing arguments that explain why firms might find it beneficial to take an “act-and-see”

approach under conditions of uncertainty rather than “wait and see.”The insights challenge the widely held assump-

tion of R&D as being risky and provide further explanations for the positive, statistically significant coefficients

found in recent empirical work on the relationship between uncertainty and R&D intensity (Bromiley et al.,2017).

Second, by combining industry-wide demand uncertainty with factors that determine firm-specific learning, we

specify organization-environment interactions that bound the ex ante value of investing under total uncertainty as a

source of idiosyncratic investment decisions in R&D. As these interactions help identify the effect of learning that

relates to real options (Folta, 2005), the findings shed light on the relative contribution of real options theory and

expand the literature that considers demand conditions as industry-level determinants of a firm's R&D spending

(e.g., Cohen & Levinthal, 1990). Our theory helps bridge the disconnection between rational future-oriented

336 ROSS ET AL.