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Product Development and Market Expansion: a Valuation Approach Based on Real Options

Author

Listed:
  • Andrea Gamba

    (Dipartimento di Scienze economiche (Università di Verona))

  • Alberto Micalizzi

    (Dipartimento di Finanza, Università Bocconi Milano)

Abstract

In this paper we investigate the valuation and optimal timing of the launch of two complementary/substitute products (or projects), one of which is a pilot product. As a first step, we study the problem from a strategic point of view and analyze the ability of the pilot product per se to create shareholder value. Next we provide a model to evaluate the option to launch the pilot product in order to create the option to launch the key product. The model is designed to analyze the value of the pilot product and the optimal timing to invest as functions of the degree of complementarity/ substitutability among the two products. As a specification, we analyze under what conditions it is worth investing in a pilot product with a negative NPV, whose option to invest is worthless due to perfect competition. The pilot product and the key product are driven by two different but correlated sources of uncertainty. The case is enriched by the presence of a patent on the key product and by the related consideration of a change in the competition due to patent expiry. By resorting to numerical analysis, we evaluate the embedded options and determine the optimal investment policy for both products. Our analysis allows us to capture the value of the options to invest in both the key and pilot products (as a compound option) and shows how the investment decision is a ected by a higher correlation among products and a higher degree of substitutability. The major outcome of the model is that a higher correlation and a higher degree of substitutability among products increase the option value and expand the investment thresholds of the whole investment project, thus making the investment relatively less likely in the case of either a lower correlation or a lower degree of substitutability.

Suggested Citation

  • Andrea Gamba & Alberto Micalizzi, 2002. "Product Development and Market Expansion: a Valuation Approach Based on Real Options," Working Papers 01/2002, University of Verona, Department of Economics.
    • Handle: RePEc:ver:wpaper:01/2002
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    References listed on IDEAS

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    1. Huisman, Kuno J. M. & Kort, Peter M., 2003. "Strategic investment in technological innovations," European Journal of Operational Research, Elsevier, vol. 144(1), pages 209-223, January.
    2. Andrew B. Abel & Avinash K. Dixit & Janice B. Eberly & Robert S. Pindyck, "undated". "Options, the Value of Capital, and Investment," Rodney L. White Center for Financial Research Working Papers 15-95, Wharton School Rodney L. White Center for Financial Research.
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    4. Trigeorgis, Lenos, 1993. "The Nature of Option Interactions and the Valuation of Investments with Multiple Real Options," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 28(1), pages 1-20, March.
    5. Paul D. Childs & Alexander J. Triantis, 1999. "Dynamic R&D Investment Policies," Management Science, INFORMS, vol. 45(10), pages 1359-1377, October.
    6. Kandel, Eugene & Pearson, Neil D., 2002. "Option Value, Uncertainty, and the Investment Decision," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 37(3), pages 341-374, September.
    7. Andrew B. Abel & Avinash K. Dixit & Janice C. Eberly & Robert S. Pindyck, 1996. "Options, the Value of Capital, and Investment," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 111(3), pages 753-777.
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    Cited by:

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    More about this item

    Keywords

    Marketing strategy; Real options; Option interactions; Binomial lattices.;
    All these keywords.

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies

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