Dynamic R&D projects selection: The role of uncertainty and managerial flexibility

Selecting between investing on R&D in incremental innovations and radical innovations is particularly challenging. In this paper, we focus on the problem of project selection under technical uncertainty and market uncertainty. After motivating the challenges and decisions facing firms using a real-life application from GM, we formulate a mathematical model of a firm, that must develop its products in the presence of uncertainty. Specifically, the firm faces two options: (i) an incremental innovation project that is known to be relatively easy to develop and (ii) a radical innovation project that offers superior performance but whose development is much more difficult. We examine how characteristics of R&D projects such as projects' relative efficiencies and future benefits affect R&D investment policy, valuation and risk premia. Our analysis helps understand the appropriateness of the different development approaches. We illustrate our model with a Hybrid Electric Cars vs Hydrogen Fuel Cell Vehicles example as pursued by GM and note the managerial implications of our analysis.