Optimal R&D investment for a risk-averse entrepreneur

Abstract Entrepreneurs investing in R&D projects face technical uncertainty associated with the cost to completion of the project, which is idiosyncratic and inherently unhedgeable. We extend existing real options models of R&D investment to incorporate the cost of bearing this unhedgeable risk and find it decreases risk-averse entrepreneurs’ valuations of R&D projects and increases the minimum NPVs required for continued investment in R&D (threshold NPVs) relative to ‘unpriced risk’ values and threshold NPVs. As in the ‘unpriced risk’ case, for less risk-averse entrepreneurs with small R&D projects, threshold NPVs remain negative and decrease with technical uncertainty. However, for sufficiently risk-averse entrepreneurs with sufficiently large R&D projects, threshold NPVs can become positive and increase with technical uncertainty.