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Real Options and Product Life Cycles

  • 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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    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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    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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    1. Majd, Saman & Pindyck, Robert S., 1987. "Time to build, option value, and investment decisions," Journal of Financial Economics, Elsevier, vol. 18(1), pages 7-27, March.
    2. McDonald, Robert L & Siegel, Daniel R, 1985. "Investment and the Valuation of Firms When There Is an Option to Shut Down," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 26(2), pages 331-49, June.
    3. Brennan, Michael J & Schwartz, Eduardo S, 1985. "Evaluating Natural Resource Investments," The Journal of Business, University of Chicago Press, vol. 58(2), pages 135-57, April.
    4. Saman Majd & Robert S. Pindyck, 1989. "The Learning Curve and Optimal Production under Uncertainty," RAND Journal of Economics, The RAND Corporation, vol. 20(3), pages 331-343, Autumn.
    5. Pindyck, Robert S, 1988. "Irreversible Investment, Capacity Choice, and the Value of the Firm," American Economic Review, American Economic Association, vol. 78(5), pages 969-85, December.
    6. Robert McDonald & Daniel Siegel, 1986. "The Value of Waiting to Invest," The Quarterly Journal of Economics, Oxford University Press, vol. 101(4), pages 707-727.
    7. Triantis, Alexander J & Hodder, James E, 1990. " Valuing Flexibility as a Complex Option," Journal of Finance, American Finance Association, vol. 45(2), pages 549-65, June.
    8. John A. Norton & Frank M. Bass, 1987. "A Diffusion Theory Model of Adoption and Substitution for Successive Generations of High-Technology Products," Management Science, INFORMS, vol. 33(9), pages 1069-1086, September.
    9. Cox, John C. & Ross, Stephen A. & Rubinstein, Mark, 1979. "Option pricing: A simplified approach," Journal of Financial Economics, Elsevier, vol. 7(3), pages 229-263, September.
    10. Hull, John & White, Alan, 1990. "Valuing Derivative Securities Using the Explicit Finite Difference Method," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 25(01), pages 87-100, March.
    11. Frank M. Bass, 1969. "A New Product Growth for Model Consumer Durables," Management Science, INFORMS, vol. 15(5), pages 215-227, January.
    12. Constantinides, George M, 1978. "Market Risk Adjustment in Project Valuation," Journal of Finance, American Finance Association, vol. 33(2), pages 603-16, May.
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