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Real Options and Product Life Cycles

Author

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  • Nicolas P. B. Bollen

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

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.

Suggested Citation

  • Nicolas P. B. Bollen, 1999. "Real Options and Product Life Cycles," Management Science, INFORMS, vol. 45(5), pages 670-684, May.
  • Handle: RePEc:inm:ormnsc:v:45:y:1999:i:5:p:670-684
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    File URL: http://dx.doi.org/10.1287/mnsc.45.5.670
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    References listed on IDEAS

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    1. 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.
    2. 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.
    3. 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.
    4. Frank M. Bass, 1969. "A New Product Growth for Model Consumer Durables," Management Science, INFORMS, vol. 15(5), pages 215-227, January.
    5. 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.
    6. Constantinides, George M, 1978. "Market Risk Adjustment in Project Valuation," Journal of Finance, American Finance Association, vol. 33(2), pages 603-616, May.
    7. Pindyck, Robert S, 1988. "Irreversible Investment, Capacity Choice, and the Value of the Firm," American Economic Review, American Economic Association, vol. 78(5), pages 969-985, December.
    8. Brennan, Michael J & Schwartz, Eduardo S, 1985. "Evaluating Natural Resource Investments," The Journal of Business, University of Chicago Press, vol. 58(2), pages 135-157, April.
    9. 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.
    10. Triantis, Alexander J & Hodder, James E, 1990. " Valuing Flexibility as a Complex Option," Journal of Finance, American Finance Association, vol. 45(2), pages 549-565, June.
    11. 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.
    12. 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 331-349, June.
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    Citations

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    Cited by:

    1. Oscar Gutiérrez & Francisco Ruiz-Aliseda, 2011. "Real options with unknown-date events," Annals of Finance, Springer, vol. 7(2), pages 171-198, May.
    2. Óscar Gutiérrez & Francisco Ruiz-Aliseda, 2009. "Entry Patterns Over The Product Life Cycle," Manchester School, University of Manchester, vol. 77(5), pages 594-610, September.
    3. Angel Leon & Diego Piñeiro, 2004. "Valuation Of A Biotech Company: A Real Options Approach," Working Papers wp2004_0420, CEMFI.
    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. 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.
    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 (IFAMA), vol. 10(01).

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