R&D funding decisions

The Traditional Approach to R&D Funding

The traditional funding process for research and development projects tends to result in the funding of less-risky projects. The reason is that there is usually not enough cash available to fund all proposed projects, so a ranking system must be imposed to determine which projects will receive funding. The ranking is driven by a discounted cash flows analysis, for which a higher discount rate is imposed on the riskier projects. Since this analysis tends to reduce the cash flows associated with riskier projects, only safer R&D projects are funded. The typical result is that a business pours more cash into the extension of its existing product lines, which are considered safe investments, and little cash into real innovation. The result of this approach is a concentration of products in current areas, and little chance of new product development elsewhere, which leads to stagnation.

R&D Funding Categories

One way to break through this safety-driven selection process is to deliberately allocate cash to several classifications of R&D projects, of which one is for high-risk endeavors. The amount allocated to each classification will vary, depending on management's willingness to lose money on high-risk projects. In general, this concept will increase the probability that a business will come up with a breakthrough product that can lead to an entirely new product line.

Results of R&D Funding Categories

When cash is deliberately invested in high-risk R&D projects, there will inevitably be a number of project failures, either because the results will not be commercially viable or because the project is an outright failure. The real problem is when there are few failures, because it indicates that the company is not investing in sufficiently risky projects, with their attendant high returns.

To determine the amount of project failure being experienced, summarize the total expense related to projects that have been cancelled (known as R&D waste). While this metric can be deliberately altered by delaying the date on which a project is cancelled, it can still provide relevant input into the amount of project risk being incurred over multiple periods.

Expected Commercial Value

Even when the allocation of funding into different classifications increases the odds of funding a riskier R&D project, it is still necessary to allocate funds within each classification. A possible approach for deciding between projects is to use expected commercial value (ECV), which amalgamates the probabilities of success into a more standard net present value calculation. The formula is:

(((Project net present value x probability of commercial success) – commercialization cost) x (probability of technical success)) – product development cost

Example of Expected Commercial Value

As an example of how ECV can be used, Entwhistle Electric is considering an investment in a tiny battery for cell phone applications. There is some risk that the battery cannot be developed in the necessary size. Facts pertaining to the project are:

Project net present value $8,000,000
Probability of commercial success 90%
Commercialization cost $1,500,000
Probability of technical success 75%
Product development cost $3,500,000

Entwhistle's financial analyst derives the following ECV for the project from the preceding information:

((($8,000,000 Project NPV x 90% probability of commercial success) – $1,500,000 commercialization cost) x (75% probability of technical success)) – $3,500,000 product development cost

Expected commercial value = $775,000

Subsequent R&D Project Analysis

An ECV analysis will inevitably result in some projects not being funded. However, not being funded does not necessarily equate to being permanently cancelled. These projects might become more tempting prospects for funding at a later date, depending on changes in such areas as:

Because of these issues, it may make more sense to schedule an occasional review of projects that have failed the ECV test, to see if circumstances now make them worthy of an investment.

Related Courses

Capital Budgeting 
Financial Analysis