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Real Options and Product Life Cycles

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Author Info

  • Nicolas P. B. Bollen

    (Department of Finance, David Eccles School of Business, The University of Utah, Salt Lake City, Utah 84112)

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    Abstract

    In this paper, I develop an option valuation framework that explicitly incorporates a product life cycle. I then use the framework to value the real option to change a project's capacity. Standard techniques for valuing real options typically ignore product life cycle models and specify instead a constant expected growth rate for demand or price. I show that this specification can lead to significant error in the valuation of capacity options. In particular, the standard technique tends to undervalue the option to contract capacity and overvalue the option to expand capacity. This result has important implications for capital investment decisions, especially in high-technology industries that feature regular introductions of newly improved products.

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    File URL: http://dx.doi.org/10.1287/mnsc.45.5.670
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    Bibliographic Info

    Article provided by INFORMS in its journal Management Science.

    Volume (Year): 45 (1999)
    Issue (Month): 5 (May)
    Pages: 670-684

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    Handle: RePEc:inm:ormnsc:v:45:y:1999:i:5:p:670-684

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    Related research

    Keywords: real option; product life cycle; contingent claim;

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    Cited by:
    1. Angel Leon & Diego Piñeiro, 2004. "Valuation Of A Biotech Company: A Real Options Approach," Working Papers wp2004_0420, CEMFI.
    2. Arthur E. Attema & Anna K. Lugnér & Talitha L. Feenstra, 2010. "Investment in antiviral drugs: a real options approach," Health Economics, John Wiley & Sons, Ltd., vol. 19(10), pages 1240-1254.
    3. Oscar Gutierrez Arnaiz & Francisco Ruiz-Aliseda, 2003. "Real Options with Unknown-Date Events," Discussion Papers 1378, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
    4. Qin, Ruwen & Nembhard, David A., 2012. "Demand modeling of stochastic product diffusion over the life cycle," International Journal of Production Economics, Elsevier, vol. 137(2), pages 201-210.
    5. Oscar Gutierrez Arnaiz & Francisco Ruiz-Aliseda, 2003. "Entry Patterns over the Product Life Cycle," Discussion Papers 1380, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
    6. Liu, Juan & Sporleder, Thomas L., 2007. "Growth-related Measures of Brand Equity Elasticity for Food Firms," International Food and Agribusiness Management Review, International Food and Agribusiness Management Association (IAMA), vol. 10(01).

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