We consider a firm that employs human capital to make a technological breakthrough. Since the probability of success of the breakthrough depends on the current stock of human capital the firm has an incentive to expand its human capital stock. The present value of the patent is stochastic but can be observed during the R&D phase of the project. The exogenous value of the patent determines the firm’s decisions to invest in human capital, to abandon the project if necessary, and to invest in marketing the new product. We study the corresponding optimal stopping times, determine their value and risk consequences, and derive optimal investment in the stock of human capital. While optimal investment in human capital is very sensitive to its productivity do increase the probability of a breakthrough it is insensitive to changes in the volatility of the present value of the patent. The value of the firm is driven by fixed labor costs that occur until the breakthrough is made, the call option to invest in human capital and market the product, and the put option to abandon the project. These options together with labor costs’ based operating leverage determine the risk dynamics. Firm risk is inverse U-shaped and critically depends on the option to increase the stock of human capital, operating leverage arising from labor costs and the option to shut down if patent values are unattractive.
Main Research Area:
Real Options 15th Annual International Conference, 2011