CHAPTER 7

Choosing Innovation Projects

SYNOPSIS OF CHAPTER
This chapter overviews the most commonly used qualitative, quantitative, and combination
methods used to evaluate new product development projects. The chapter emphasizes that each
method has its strengths and weaknesses, and that most firms will (or should) use a combination
of methods in order to triangulate their information about a project’s prospects.

The chapter begins by discussing the role of the development budget, including capital rationing,
and differences in R&D spending across industries and across firms within industries. The
chapter then reviews popular quantitative methods (e.g., NPV, IRR, Real Options methods) for
project valuation, then turns to qualitative methods (e.g., screening questions, Qsort, balancing
the company’s R&D portfolio), and methods that are both quantitative and qualitative (e.g.,
conjoint analysis, data envelopment analysis).

TEACHING OBJECTIVES
1. Familiarize students with the wide variety of methods available (both quantitative and
qualitative) to evaluate innovation projects.
2. Highlight the important role played by managerial assumptions in the accuracy and
utility of any measure used.
3. Emphasize the importance of a balanced R&D project portfolio (i.e. advanced R&D,
breakthrough, platform, and derivative).

LECTURE OUTLINE
I. Overview
A. New product development is inherently risky and expensive, putting pressure on
managers to make careful choices among projects.
B. Firms use a mix of formal, informal, quantitative and qualitative methods when
selecting and managing innovation projects and each of these methods has its own
strengths and weaknesses. Often the choices are driven by strategic implications rather
than strictly financial analysis (this is a good point to have students discuss some of the
strategic implications considered in the decision to develop the Boeing Sonic Cruiser).

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II. The Development Budget
A. Many firms use capital rationing (a fixed R&D budget and project rankings) to
choose between valuable projects. Firms might establish this budget based on
industry benchmarks, historical performance benchmarks and/or on a desired
level of R&D intensity.
B. Expenditures on R&D vary widely between industries and between firms in the
same industry.

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1. For example, Dell Computer’s R&D intensity is significantly lower than

the industry average (1.5% versus 6.4%), and Ford Motor spends
considerably more than the industry average (4.5% versus 2.9%). The
table in transparency 3 highlights the impact of firm size on R&D budgets.

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C. New ventures often have to rely on external financing, family, friends, and/or
personal debt because technology start-ups often have an unproven technology,
an unproven business concept and/or an unproven management team. Three
additional sources of financing are:
1. Government grants and loans from agencies such as the Small Business
Administration in the U.S. or the Enterprise fund in the UK.
2. Angel investors are similar to venture capitalists but without the limited
partnership structure. Angel investors usually fund projects under $1
million and financed about 50,000 deals in 2002.
3. Independent or corporate venture capitalists invest on average $10.5
million in each project and usually specialize in one or a few industries in
which they can leverage their expertise. Financing is usually accomplished
through a complex debt-equity hybrid contract. Corporate venture
capitalists (233 in 2003) are organized in one of two ways, via an internal
venturing group or as a dedicated external fund. The pros and cons of
each structure are summarized below:
a. Internal venturing groups are in a better position to use the
firm’s expertise and resources to help a new venture succeed.
Entrepreneurs may be concerned about the larger firm
expropriating the entrepreneur’s proprietary technology under this
structure.
b. Entrepreneurs are more likely to trust a dedicated external fund
because it is less likely that these funds will have the expertise or

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 desire to steal their ideas. On the downside, the ability of the
entrepreneur to leverage any of the larger firm’s non-financial
resources is more limited.
III. Quantitative Methods for Choosing Projects
A. Discounted cash flow and real option analyses differ in that the real options
approach facilitates the consideration of a project’s strategic importance. Both of
these approaches allow rigorous mathematical and statistical comparisons of
projects. The accuracy of these methods is, however, questionable because the
value of a new technology is difficult to know in advance and because these
methods favor short-term low risk investments. For example, Intel’s investment
in DRAM technology enabled Intel to develop microprocessors, which turned out
to be a very profitable business. From a NPV perspective this project is likely to
have been considered a total loss.
1. Discounted Cash Flow Methods (NPV & IRR) rest on estimates of
future returns, payback period, risk, and the time value of money. The
NPV asks what the project is worth today and the IRR asks what rate of
return does this project yield.
a. Net Present Value (NPV) compares the present value of cash
inflows to the present value of cash outflows. In transparency 4,
the present value of the future cash flows (given a discount rate of
6%) is $3,465.11. So, if the initial cost of the project were less
than $3,465.11, the net present value of the project is positive.

Show Transparency 4

If cash inflows are expected to be roughly equal from year to year

for a very long period of time, the value of them can be calculated
as an annuity. The present value of C dollars per period, for t
periods, with discount rate r is given by the following formula:

1 1/1r t 
Annuity present value C X  
r
Perpetuity present value C X 1r

Managers also consider the discounted payback period. In the

above example, if the initial investment was $2,000 it would be

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 paid back between the end of year two ($1,833.40) and the second
month of year three ($166.60).

Year Cash Flow

1 $ 934.40
2 $1,833.40
3 $2,673.02
4 $3,465.11

b. Internal Rate of Return (IRR) identifies the discount rate that

makes the net present value of the investment zero and is difficult
to calculate when cash flows arrive in varying amounts per period
because there can be multiple rates of return.
2. Real Options thinking is most useful when there is uncertainty (and
there usually is high uncertainty when technology trajectories are
considered) and when a firm’s investment in its own learning,
development of new capabilities and the creation of opportunities are
important factors in the decision making process. There is some empirical
evidence that a real option approach results in better investment
decisions.
a. Real options are analogous to call options on a stock. A call
option gives the investor the right to buy the stock at a specified
price (i.e. exercise price) in the future. Examples of this type of
investment decision are shown in transparency 5.

R&D costs = Call option price

Costs to capitalize on R&D = Exercise price
Returns to R&D investment = Value of the stock purchased with the
call option

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The value of a call option rises with the value of the stock, dollar
for dollar (45° angle) once the option is “in the money” and is zero
otherwise.

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b. The analogy can be stretched too far, however. Technology
investments often do not conform to the same capital market
assumptions upon which the approach is based. For example,

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 1) Call options are relatively inexpensive but real options
can be very expensive because firms may have to make
large investments in a technology before they can learn
whether or not the real option is valuable.
2) Call option value is independent of the call holder’s
behavior but real option value is highly dependent on the
resources (e.g. dollars, capabilities, complementary assets,
strategies) a firm invests in developing a technology.
IV. Qualitative Methods for Choosing Projects
A. Most firms will use both quantitative and qualitative evaluation approaches
(ranging from informal discussions to highly structured decision processes)
because many of the factors important to the decision are extremely difficult to
quantify and attempts to quantify these factors can lead to misleading results.
B. Boeing’s development of the Sonic Cruiser is an example of a development
project that may not be profitable but may at the same time be necessary when the
importance of firm capabilities is considered.
C. Screening Questions are organized into categories (see below) and are used by
managers to structure technology project investment discussions. If managers
want to formalize the process they can utilize a scoring mechanism (i.e. scaled
responses to each question like “Project fits closely with existing competencies”
to “Project fits poorly with existing competencies”) that can then be weighted
according to importance. Sample screening questions follow (a more extensive
list can be found in the text):
1. Role of Customer―How big is the market of likely customers and what
types of marketing will reach them best? How will the customer value
the product relative to substitutes? How will the customer perceive the
ease-of-use of the product (e.g. complements, training, etc.)? How will the
product be distributed?
2. Role of Capabilities―What affect will the new project have on current
core competencies (e.g. leverage, obsolete). Will the firm be able to
handle the possible cash flow implications? What new competencies will
the firm have to develop and will these new competencies help the firm
achieve its strategic intent?
3. Project Timing and Cost―Does the firm have a choice with regard to
entry timing (i.e. does the firm have the capabilities to be a first mover)?
How variable are the projected costs and learning curve effects?
D. Mapping the Company's R&D Portfolio focuses a firm’s attention on the mix
of development projects (advanced R&D, breakthrough, platform, and derivative)
in its R&D portfolio in order to determine whether the projects are consistent with
the company’s resources and strategic intent. The map also enables firms to
determine whether its portfolio is balanced between projects with short and
long-term payoff horizons. It is important to emphasize this balance to students:

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 too much focus on short term projects can be profitable in the immediate term but
leave the company with no long-term prospects, and too much focus on the long-
term can leave the firm strapped for cash in the short run. To create the map
managers categorize their existing projects according to the resources required
and the parts of the company’s product line they support.
1. Advanced R&D projects are necessary to the development of cutting
edge strategic technologies (e.g. Honda’s work on hydrogen fuel cells). If
firm’s portfolio consists entirely of advanced R&D projects the firm may
not be able to sustain itself in the short term (i.e. no short term cash flows).
There may be no obvious immediate commercial application.
2. Breakthrough projects incorporate revolutionary new product and
process design technologies into a new product -- that is they are
oriented around a specific commercial application (e.g. Honda’s
development of Insight).
3. Platform projects generate fundamental improvements in the cost,
quality, and performance of a technology versus prior generations and are
designed to serve a core group of customers (e.g. Hunter’s “Care Free
humidifier and Toyota’s Camry).
4. Derivative projects involve incremental changes in products and/or
processes (e.g. Camry LE, Camry SE, etc. are based on the Camry
platform but target different customer segments). If a firm’s portfolio
includes only derivative projects then it may have good short-term returns
but also may not be able to compete when the market moves to a new
technology.

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a. For example, pharmaceutical firms can suddenly find a

devastating gap in its project portfolio because they have become
increasingly reliant on a new blockbuster drugs and because
projects typically have high failure rates, long development cycles,
and rely on patent protection that will expire.
E. Q-Sort is used to rank projects on a variety of dimensions. Individuals are given
a stack of cards (on each card is a development project) they put in order
according to their assessment of how well each project performs on the criteria
presented (e.g. technical feasibility, market impact, fit with strategic intent). These
rankings are then used to structure a debate about the projects.
V. Combining Quantitative and Qualitative Information
A. Conjoint and data envelopment analyses combine quantitative and qualitative
project assessments by translating qualitative assessments into quantitative
measures so that projects evaluated in different ways can be fairly compared.

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1. Conjoint Analysis is a family of techniques (e.g. Discrete Choice,
Modeling, Hierarchical Choice, Tradeoff Matrices, Pairwise Comparisons)
enabling the relative importance of product attributes to be derived
statistically. The text uses the selection of camera attributes as an
example of how multiple regression can be used to identify the weights
implicitly assigned by customers to individual criteria. In the theory in
action section Marriott’s experience in developing the Courtyard
concept is investigated.
a. Marriott used conjoint analysis to determine which features
customers would want most in a moderately priced hotel (the
segment of the industry with continued high growth). Marriott first
ran focus groups to identify customer segments and the hotel
attributes they valued. Then in an exercise similar to a Q sort hotel
customers were given a fictional $35 with which to build their
own hotel and a set of cards representing the major hotel
attributes. The tradeoffs customers made in the process of building
their hotel enabled managers to develop “hotel profiles” that
participants were then asked to rate. The managers could then use
regression to assess how different levels of service within a
specific attribute influenced customer ratings of the hotel overall.

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2. Data Envelopment Analysis (DEA) facilitates the comparison of projects

using multiple criteria and different kinds of measurement units (e.g.
dollars, rankings, Likert measures from a survey). DEA uses linear
programming to create a hypothetical “efficiency frontier” that represents
the best performance on each measure. Each project is then assigned an
efficiency value based on the projects distance from the efficiency
frontier.
a. For example, the Advanced Technologies Group of Bell
Laboratories chose to evaluate projects in terms of three
measures: discounted cash flows, the investment required, and
desirability from the perspective of intellectual property and
product market benefits. For the latter two measures, projects were
given a score of 1, 1.5, or 2.25 based on the group’s model for
intellectual property and product market benefits.

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ANSWERS TO OPENING CASE DISCUSSION QUESTIONS
1. What factors must go into Boeing’s decision about whether to continue developing – and
launching – the Sonic Cruiser?
The factors that Boeing must consider include (but are not limited to) likely demand for
the Sonic Cruiser, the impact of the Sonic Cruiser on competitive dynamics in the airline
industry, the airlines’ willingness to pay for the plane, the costs of developing the Cruiser,
how the Sonic Cruiser fits or does not fit into Boeing’s current product line (e.g.
similarity among planes reduces maintenance costs for airlines), the firm’s strategic intent
and how the development of a new plane will affect current and future firm competencies
and Boeing’s ability to create a sustainable competitive advantage.
2. What are some of the challenges with estimating the potential returns of the project?
Evaluating whether or not to develop the Sonic Cruiser will run into all of the difficulties
highlighted in this chapter. Boeing has to evaluate both quantitative data and qualitative
data and in this case the analyses seem to be pointing in different directions.
3. What method, or combination of methods, do you think Boeing should use to evaluate the
project?
This is a complex and important decision for Boeing so they should first use a mix of
quantitative and qualitative methods (including discounted cash flows and the use of
screening questions). Boeing might particularly benefit from utilizing a Q sort method so
that all managers can become familiar with both the financial and strategic implications
of the decision. It would be very interesting to see the implicit rankings managers place
on each of these criteria. A data envelopment approach would not be appropriate because
Boeing is only considering one project as the case is written.
4. Should Boeing continue developing the Sonic Cruiser? If so, should Boeing attempt to
commercially produce and launch the Sonic Cruiser?
It is important for your students to take a position on these questions. It may be
interesting to use their answers as part of a class exercise in which you analyze their
implicit rankings of factor importance in the decision they made. A first step in making
this decision would be to get a realistic appraisal of likely demand from the airlines. If
demand is strong, students may recommend that Boeing develop and commercially
produce the Sonic Cruiser. If demand is soft students might suggest that Boeing use its
considerable talents to develop a plane that airlines would want to purchase, however it is
important for them to not lose sight of Boeing’s need to develop a major new product to
reinvest in its new product develop competencies. Students might suggest that Boeing
form a partnership with one of the airlines to develop their plane of choice (to decrease
risk, assure demand, and ensure that customer requirements are reflected in the plane’s
design).

ANSWERS TO DISCUSSION QUESTIONS

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1. What are the advantages and disadvantages of discounted cash flow methods such as
NPV and IRR?
The main advantage of these methods is their ability to support rigorous mathematical
and statistical comparisons of innovation projects. Though these methods look good on
the surface their accuracy relies on the accuracy of the assumptions made by managers
and these assumptions can be inaccurate and lead to misleading results. This is especially
true in the realm of technological innovation because it is often next to impossible to
know a technology’s trajectory before it unfolds. Another significant disadvantage of
these methods is that they do not incorporate information regarding the strategic
important of a project.
2. For what kind of development projects might a real options approach be appropriate?
For what kind of projects would it be inappropriate?
The real options approach is most appropriate when there is significant uncertainty
concerning the outcomes of an innovation project and/or when a firm’s investment in its
own capabilities is an important consideration. One could also argue that a real options
approach is most appropriate when the investment is most similar to a call option (i.e.
small initial investment and not dependent on the investors behavior). Finally a real
options approach is best used when evaluating advanced R&D and breakthrough projects.
Real options may be more complex than is necessary when it comes to evaluating
platform and derivative projects
3. What are some of the reasons that a firm might use both qualitative and quantitative
assessments of a project?
The primary reason to use both qualitative and quantitative assessments of a project is to
provide a complete view of the project’s potential. A project’s potential profitability is
important but it is hard to assess using only information that is available in a quantitative
form, and is also not the whole picture. The strategic implications of an innovation must
also be taken into account and qualitative measures are more suited to evaluating this
type of outcome.
4. Identify a particular development project you are familiar with. What kinds of methods
do you believe were used to assess the project? What kinds of methods do you believe
should have been used to assess the project?
Students should provide their own examples here; one student example obtained
previously went as following: “I led a team that was charged with assessing whether or
not our firm could make use of new biotechnology based forms of identification. In
addition to calculating the benefits of using these technologies to combat fraud we
conducted focus groups to determine customers reactions to each technology (e.g. eye
scans, hand geometry, fingerprints, voice recognition, handwriting recognition).At one
point the team was very divided over which technology we should recommend and we
employed a procedure similar to a Q sort to break the logjam. This method allowed us to
separate our evaluation of each factor from its relative importance and allowed the team
to come to a conclusion (voice recognition). I think we should have also considered
whether it was the best strategic move to be among the first adopters of this technology in
our industry.”

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5. Will different methods of evaluating a project typically yield the same conclusions about
whether to fund its development? Why or why not?
On one level it is unlikely that different methods will yield the same conclusions because
they apply different criteria (e.g. financial, strategic, etc.). On another level we could
expect different methods of evaluating a project to yield the same conclusions because all
of these methods rest wholly or in part on managerial assumptions and these assumptions
are likely to be the same regardless of the method used.

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