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Product Development and Market Expansion: A Real Options Model

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  • Andrea Gamba
  • Alberto Micalizzi

Abstract

We create a model that values complementary and substitute products with potentially correlated revenues, which must be developed sequentially. The model also incorporates the effects of changing market conditions. We find that the value of a combined project increases in correlation, but the probability of investing in the initial product is a decreasing function of correlation. These results are reversed if the products are substitutes. Regardless of the correlation level, higher levels of substitutability reduce the value of the combined projects and increase the probability of investing. Despite greater uncertainty during the phase of limited competition, the firm is more likely to invest early than to postpone investment. Copyright (c) 2007 Financial Management Association International.

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Bibliographic Info

Article provided by Financial Management Association International in its journal Financial Management.

Volume (Year): 36 (2007)
Issue (Month): 1 (03)
Pages: 91-112

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Handle: RePEc:bla:finmgt:v:36:y:2007:i:1:p:91-112

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  1. Andrew B. Abel & Avinash K. Dixit & Janice C. Eberly & Robert S. Pindyck, 1995. "Options, the Value of Capital, and Investment," NBER Working Papers 5227, National Bureau of Economic Research, Inc.
  2. Huisman, K.J.M. & Kort, P.M., 1998. "Strategic Investment in Technological Innovations," Discussion Paper 1998-114, Tilburg University, Center for Economic Research.
  3. Kandel, Eugene & Pearson, Neil D., 2002. "Option Value, Uncertainty, and the Investment Decision," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 37(03), pages 341-374, September.
  4. Baldwin, Carliss Y, 1982. " Optimal Sequential Investment When Capital Is Not Readily Reversible," Journal of Finance, American Finance Association, vol. 37(3), pages 763-82, June.
  5. Margrabe, William, 1978. "The Value of an Option to Exchange One Asset for Another," Journal of Finance, American Finance Association, vol. 33(1), pages 177-86, March.
  6. Carr, Peter P, 1988. " The Valuation of Sequential Exchange Opportunities," Journal of Finance, American Finance Association, vol. 43(5), pages 1235-56, December.
  7. Paul D. Childs & Alexander J. Triantis, 1999. "Dynamic R&D Investment Policies," Management Science, INFORMS, vol. 45(10), pages 1359-1377, October.
  8. Jonathan B. Berk, 2004. "Valuation and Return Dynamics of New Ventures," Review of Financial Studies, Society for Financial Studies, vol. 17(1), pages 1-35.
  9. Childs, Paul D. & Ott, Steven H. & Triantis, Alexander J., 1998. "Capital Budgeting for Interrelated Projects: A Real Options Approach," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 33(03), pages 305-334, September.
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