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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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  • Andrea Gamba & Alberto Micalizzi, 2007. "Product Development and Market Expansion: A Real Options Model," Financial Management, Financial Management Association International, vol. 36(1), pages 91-112, March.
  • Handle: RePEc:bla:finmgt:v:36:y:2007:i:1:p:91-112
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    References listed on IDEAS

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    1. 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.
    2. 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.
    3. 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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    6. Carr, Peter P, 1988. " The Valuation of Sequential Exchange Opportunities," Journal of Finance, American Finance Association, vol. 43(5), pages 1235-1256, December.
    7. 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.
    8. 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, Oxford University Press, vol. 111(3), pages 753-777.
    9. Margrabe, William, 1978. "The Value of an Option to Exchange One Asset for Another," Journal of Finance, American Finance Association, vol. 33(1), pages 177-186, March.
    10. Baldwin, Carliss Y, 1982. " Optimal Sequential Investment When Capital Is Not Readily Reversible," Journal of Finance, American Finance Association, vol. 37(3), pages 763-782, June.
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