Product Development with Value-Enhancing Options
47 Pages Posted: 23 Mar 2007
Date Written: March 2007
We study path-dependent value-enhancing managerial actions with random outcome. These actions are either uncertainty revealing actions like research, experimentation, and early versions (pilot projects) or actions that are expected to increase value like attribute enhancing development options and advertising that have however an uncertain outcome. Actions are costly (costs may be partially reversible), sequential and implemented by management at optimal time. We derive two-stage analytic formulas and we use them to study product development with optimal timing of product versions and sequencing of value enhancing actions. We also analyze a multi-period version of the problem using a numerical lattice solution. Individual research/exploration actions are more important when the project is at the money (projects near zero NPV) and less important for low or high values of project value. In a multi-stage setting exploration actions are often important even in very in-the-money projects when follow on actions exist that can enhance the expected value of the project. With path-dependency, early actions can become more valuable when they enhance the impact or reduce the cost of later actions.
Keywords: Real options, economics of R&D, technical risk, path-dependency, sequential (compound) options, early versions (pilot projects) with cash multiplier, jump-diffusion
JEL Classification: G13, G31
Suggested Citation: Suggested Citation