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Real Option Valuation of Product Innovation

Diplomarbeit 2007 86 Seiten

BWL - Investition und Finanzierung


Table of Contents


1. Introduction
1.1. The Problem: Valuing Product Innovation
1.2. Goals of the Thesis
1.3. Methodology

2. Basic Concepts of Valuing Product Innovation
2.1. Definition and Character of Product Innovation
2.2. Definition of Product Innovation
2.3. Character of Product Innovation
2.4. Product Innovation is a Complex Process
2.4.1. Product Innovation is a Cross-functional and Contingent Process
2.4.2. Product Innovation is a Risky Process
2.5. Main Challenges in Valuing Product Innovation
2.5.1. Selection of the Adequate Methodology
2.5.2. Net Present Value
2.5.3. Other Traditional Approaches

3. Introduction of Real Option Valuation
3.1. Definition of an Option
3.2. Difference between Real Options and Financial Options
3.3. Value Drivers of Real Options
3.3.2. Value Drivers Relating to the Underlying Asset and Financial Market
3.3.3. Managerial Flexibility
3.3.4. Uncertainty
3.4. Typology of Real Options
3.4.1. The Option to Delay and the Valuing
3.4.2. The Option to Expand and the Valuing
3.4.3. The Option to Contract and the Valuing
3.4.4. The Option to Abandon and the Valuing
3.4.5. The Option to Switch and the Valuing
3.4.6. Compound Options and the Valuing
3.5. Methodology of Real Option Valuation
3.5.1. Black-Scholes Model
3.5.2. Binomial Tree Model
3.5.3. Selection of the Adequate Methodology

4. Applying Real Option Valuation to the Illustration with BlackBerry 9900
4.4. Introduction of the Product Innovation with BlackBerry 9900
4.5. Valuing Process of the Chosen Example
4.5.1. First Step: Valuing without Flexibility ¾ Traditional DCF Method
4.5.2. Second Step: Model the Uncertainty ¾ Using Event Tree
4.5.3. Third Step: Identity and Incorporate Managerial Flexibility ¾ Creating a Decision Tree
4.5.4. Fourth Step: Conduct Real Options Analysis

5. Conclusion
5.4. Thesis Summary
5.5. Limitation of Real Option Valuation
5.6. Possible Complementation of Real Option Valuation
5.6.1. Combining ROV and DCF
5.6.2. Other Possible Complementation

6. Appendix
6.4. References
6.5. Website
6.6. Table of Figures


Global competition, emerging technologies, and an ever increasing need for superior products in shorter time frames all contribute to drive companies to adopt new and innovative approaches to product innovation. Effective product innovation is imperative for the survival, growth and profitability of most design and manufacturing enterprises (Cooper et al, 1998). In the current dynamic manufacturing environment, companies must innovate successfully if they wish to remain competitive. Product innovation is a complex, cross-functional and contingent, dynamic process, which is difficult to manage (Crawford, 1996). Anticipating change and expeditiously responding to the dynamics of the business environment via product innovation are important precursors for achieving sustainable competitive positions and exceptional performance[1]. The heart of a product innovation is its value.

Traditional discounted cash flow approaches, such as net present value (NPV), have traditionally been the preferred methods for evaluating investments in product innovation. The traditional NPV method, which was initially developed to value bonds or stocks by passive investors, implicitly assumes that corporations hold a collection of real assets passively. Managerial choices (as delay, expand, switching etc.) are thus presumed to be limited to the initial decision[2]. Therefore, traditional valuation methods undervalue the product innovation because they are unable to capture the value of management flexibility.

Recently, real options emerged as an alternative to simplistic discounted cash flow methods. Real option valuation (ROV) values the managerial flexibility to make ongoing decisions regarding implementation of investment projects and deployment of real assets. ROV extends valuation models used to price financial options and applies them to investments in real assets[3]. Black and Scholes (1973) developed the Black-Scholes model to value financial options that focus on factors affecting the value of the underlying financial asset over time. Proof by Cox, Ross, Rubinstein (1979), binomial tree model is simpler to understand for the practitioner and less elegant than Black-Scholes model. It uses the discrete mathematics to achieve the isomorphic results to the calculation used by Black-Scholes model[4].

From an intuition point of view, the managerial flexibility is easy to understand. But, how much it is worth is most difficult or even impossible to think about and measure with the traditional valuation methods. In this paper, we will use some concrete examples to illustrate the powerful ability to quantify the managerial flexibility and strategic interactions using real option valuation.

The four-step process to evaluate the real options, explained by Tom Copeland in his book “Real Options”, makes the application of real option valuation more practical and traceable. In this paper, we set a fictive example with an illustration of BlackBerry 9900 to systematically clarify the framework and the process of real options method

Real option valuation is theoretically the most advanced tool for the valuation of uncertainty and managerial flexibility. But the difficulties in estimating the input data, mathematical calculation, and understanding this concept by client limit the applicability of real option valuation[5]. To develop generic options based users friendly software package to reduce the mathematical difficulty[6], to analyze more actual case applications would be the possible implementation in the future.

Real Option Valuation of Production Innovation

¾ with BlackBerry 9900 as an Illustration

1. Introduction

1.1. The Problem on the Valu ing Product Innovation

Nowadays change in business environment is incessant and ubiquitous. Globalization; social, political, and economic pressures; technological innovation, turbulent market conditions and trends have shortened product life cycles and created demands for better, cheaper, cleaner, safer, and more effective products. Innovation is the key driver of competition advantage, growth, and profitability. It is one of the most important tools for a company to ensure the survival and leading position in changing market. There are many parts of the whole field of innovation: strategy innovation, new product development and innovation, creative approaches to problem solving, idea management, suggestion systems, etc. All of them are important. Product innovation involves developing new solutions that provide positive benefits to customers and stakeholders. It is the fundamental management construct used for creating new products, reinvigorating existing products, and solving product-related difficulties with customers and stakeholders[7].

A report in the McKinsey Quarterly in April 2006 of a McKinsey Global Survey shows that an executive taken on the top business trends cited a broad range of factors that they look as contributing most to the accelerating pace of change. Among them, the innovation in products, services, business models shows most prominently, with 24 percent of the responses. The following graphic[8] shows a part of results from the Survey.

Innovation in products, services and business models contributes most to the accelerating pace of change in the global business environment because that:

- Product/service innovation is the result of bringing to life a new way to solve the customer's problem – through a new product or service development – that benefits both the customer and the sponsoring company
- Through providing new, improved, or cheaper products, company could either raise the quality of product or decrease its costs. Therefore, a successful product innovation strengthens company’s competitiveness in market.
- In order to capture the market opportunity, old products must be innovated or replaced on time. If exists, with the new product,. The product innovation could reduce the existing strategic gap in the market development.
- The increasing application of new technology spaces the product innovation. A product innovation keeping pace with technology could strengthen the company’s core competence, so that the potential threats for the company would be reduced.

illustration not visible in this excerpt

As for any innovation, changing market and non-plentiful information from environment surrounding the company, product innovation and product innovation process are always under uncertainty. For example, how do we forecast the market potential? How much is the market volume? How would competitors influence the market? What is a suitable price? How about the risk to develop a product and to go on the market? Normally, a product innovation process takes a long time from creating a new idea to bringing a new product into market. There is plenty of predictable and unpredictable uncertainty in a more and more complex market. Throughout anticipation in product innovation managers often have a wide range of possibilities to react flexibly to the fast changing business environment. Managerial flexibility can be created if managers capture the area of tolerance in investment decisions based on company’s resources. Thus, it is a great challenge how to value a product innovation project before we start to do it.

1.2. Goal of the Thesis

Usually, managers try to capture a future development with “static” methods of capital budgeting, i.e. future cash flows are discounted with a fixed risk-adjusted discount rate. This method ignores the value of management flexibility and the affect of company’s resources on management decisions (would be illustrated in section 2.3). It only assumes a “now” or “never” approaches in undertaking a project. With these traditional instruments of investment evaluation, the value of modification and managerial flexibility could not be captured. Therefore, the investment decision is often undervalued with traditional valuation method.

Real option valuation and its “forward-looking” character is an improvement of traditional valuation tools. It evaluates future projects with more accuracy and methods that are approved by financial markets.

The goal of this paper is to show you the advantages of real option valuation over traditional methods for investment decisions regarding product innovation and to introduce you some useful tools in real option valuation. Start with analyzing product innovation process in chapter 2, we will illustrate why real option valuation is more suitable for valuing a product innovation project. In chapter 3, we will explain how real option valuation and its “forward-looking” character improves the traditional valuation method, how real option valuation introduces additional value drivers. With some concrete examples in section 3.4 we will demonstrate the powerful ability to quantify managerial flexibilities using real option valuation and explain how to value a single real option using replicating portfolio. Thereafter we will spread the real option from one step per time to many by using binomial tree method. In chapter 4, with a chosen example from BlackBerry 9900, we will illustrate how to systematically complete a real option valuation using the four-step valuation process.

1.3. Methodology

Net Present Value method (NPV):

Net Present Value method is a common method used to value a product innovation project. It measures the excess or shortfall of cash flows in present value terms by using a discount rate. This method takes some uncertainty into account through using the weighted average capital costs (WACC). WACC represents the correlation of an asset’s value with the broader economic system. For example, the systematic risk in a chemical plant expansion is the correlation of the plant’s value with a broad-based stock market index such as the S&P 500[9]. In this valuation method, the assumption of WACC keeps constant during the whole product innovation process.

Real Option Valuation:

As the extension of financial option theory of options, the real options approach focuses on total risk and decides on real (non-financial) assets. A real asset is a resource that is controlled by the enterprise as a result of past events (for example, purchase or self-creation) and from which future economic benefits (inflows of cash or other assets) are expected.[10] Real Option Valuation allows adaptation and revision of future decisions in order to get managerial flexibility and to finally capitalize on any possible future development[11]. Real options limit losses and offer a vital contribution to long-term corporate success, especially in those marketplaces characterized by uncertainty and rapid change. Incorporating this method could possibly lead to a better understanding of the importance of resource allocation, the value of strategic investments and the interdependencies between uncertainty and irreversibility of a project[12]. Through identification of additional value drivers and proper management, the resources are allocated optimally, contributing to the overall goal of formulating a strategy to product innovation in an uncertain environment.

In real option, managers are making contingent decisions – decisions to investment or disinvest that depend on unfolding events. A project has real option characteristics when management has the ability to change the initial strategy for a project under uncertainty, involving irreversible investment, based on new information about an uncertain factor that affects the project value

The following example shows one of differences between net present valuation and real option valuation. Suppose you are going to invest $150 million over the next 2 year ($50 million immediately and $100 million next year) to build a new product plant that will last 8 years, generate a new stream of revenues that starts at $80 million at the end of the second year and grows at 8 percent. The total costs of $60 million start in the second year and grow at 6 percent annual. There are no other costs. The average cost of capital is 10 percent.

illustration not visible in this excerpt

Figure 1: Calculation of net present value

The net present value in Figure 1 is –14.05 million dollars, and its logic suggests that the project should be rejected.

Real option valuation takes the future events into account. Suppose that we are just planning the investment. We get the information that the risk-free interest rate from the second year may decline to 5%, therefore the average cost of capital may decline to 6%, so, we decide to wait until that the risk-free interest rate from second year is sure to decline to 5%. Then we start to invest. The value of the project would be calculated as in Figure 2:

illustration not visible in this excerpt

Figure 2: Calculation of real option valuation

The net present value is $8.04 million dollars. According the investment logic this investment is feasible if we start to invest in one year. Comparing the different results in Figure 2 and Figure 1, the increased NPV 22,09 million dollars is from the management decision to capture the flexibility due to change of interest rate.

This is only an oversimplified example. In chapter 3 we will clarify differences between NPV and ROV more clearly.

2. Basic Concepts of Val uation on Product Innovation

2.1. Definition and Character of Product Innovation

A product is an output provided from a company into the market. A product satisfies the concrete customer demand through its special functionality and attributes. This satisfaction for a marketable product is often measured by the customer utility. The proposition of the customer utility is composed of the following three components (see Figure 3)

- Product/service attributes
- Image
- Customer relationship

Generic Model

illustration not visible in this excerpt

Figure 3: The Customer Utility Proposition

Source: Kaplan, Robert S. The balanced scorecard, page 74, adopted from the script Marketing from Prof. Dr. Martin Selchert

2.1.1. Definition of Product Innovation

Product innovation is defined to increase any consumer utility in order to create more value for company. It is one of technological innovations which are involved in use of new knowledge to create and implement some new technologies[13]. The utility can be effective only if the innovating firm invests also in marketing, so that consumers become aware of the newly developed product. There are two dimensions in product innovation definition: one is that innovation is related to the product. Another dimension is that the product innovation must be introduced to markets where products can be sold. Thus, the marketing of product innovation and the introduction of a product innovation are sequential steps of an effort to maximize the profit[14].

Product innovation is concerned with change. Depending on the degree of change and novelty, product innovation can be differentiated between original product innovation and adopted product innovation[15]. Original product innovation is transformational innovation. It is to create a new product with new function, or apply new principles for functionality. Through original product innovation the product attributes will be fundamentally changed, for example, Windows Vista versus Windows 95. Normally, there is no predecessor in the market. The company has to build new markets. We call this innovation product-diversification. If the company provides the new product in an old market, we call this innovation product-differentiation.

Adopted product innovation concentrates on improving a product in the old market. It is often a substantial innovation. There are four different sorts of adopted product innovation: product-modification, product variation, product standardization, and copying. Product modification improves concrete product function or changes the customer utility in consideration of market demand[16]. In contrast, product variation is only a small adjustment to the customer demand.

On the basis of an output-orientated prospect, product innovation in this paper is understood as product diversification, product differentiation and product modification, - transformational product innovation process. A graphical presentation for the classification of product innovation is given in Figure 4[17].

There is, however, no sharp distinction among different classes. If, for example, a company makes radical improvement of a product which has been developed and introduced by another company, it may be difficult that such an innovation should be called as an original or adopted innovation.

existing product programme

illustration not visible in this excerpt

Figure 4: Classifying of product innovation orientated by output and process

2.1.2. Character of Product Innovation Product innovation is a complex process

Product innovation is a complex process, requiring the use of knowledge in order to create and apply something new. Product innovation process takes a relative long time until it has significant influence on the market and production potential. This process can be divided into four stages[18]:

- Generation of ideas
- Utilisation of ideas
- Preparation for implementation
- Manufacturing and marketing

illustration not visible in this excerpt

Figure 5: Product innovation process

Source: Pleschak, F./Sabisch, H.: Innovationsmanagement, 1996, P24

Creativity, or a creative thinking, which results in novel and worthwhile ideas, is required at all stages. However, it is most important at the first stage, the generation of the basic idea, as this determines the course of other stages.

Generation of ideas represents a coupling of a perceived need and a technological opportunity that satisfies the need. The appropriate tool groups at this stage are need-related intelligence, technology-related intelligence, forecasting techniques, methods for development of creativity, preliminary studies and project formulation. This stage ends with an idea that is evaluated and accepted for further processing.

Utilisation of ideas is basically a problem-solving process aiming at an optimal technical solution for the problem specified or implied by the accepted idea. It is brought about by acquisition of the appropriate technology or by developing it inside the company. The tool groups for this stage are preliminary project analysis, market research, cost estimates, design, design evaluation and design calculation.

Preparation for implementation is concerned with planning the manufacturing and marketing operations of the new or improved product. It involves a number of tasks in connection with finalising the design of the product, planning of plant, equipment and manufacturing operations, as well as planning of the introduction and marketing operations.

Manufacturing and marketing starts with market introduction and continues with regular manufacturing and marketing. It involves the break-in and debugging of the manufacturing operation, marketing plans and the introduction at the market place. Product Innovation is a cross-functional and contingent process

Product innovation process takes a long time. The result of the innovation activities depends on a number of factors. A successful product innovation depends on a successful systematic integration of technology, organization, market and so on. Managers manage the product innovation process with analysing the resources all along. Such a flexible way of management plays an important role in innovation process. The following brain-map illustrates the possible factors influencing innovation activities:

illustration not visible in this excerpt

Figure 6: Possible factors which influence innovation activities Product Innovation is a risky Process

The investment on a product innovation project is a risky process. On one hand, the investment to introduce new product and develop market is enormous. On the other hand, the possibility of failure in the development of a new product is very high. According to the study of Arthur D. Little (a counsellor), only one of 100 new product ideas can become successful in reality.

The cost increases progressively with the increasing grade in process of new product innovation. One goal of product innovation is earning economic and technological power in the future. But the precondition is that the company has to afford a great deal of financial and human resources first. In addition to the investment in R&D and market research, there are also the costs for product-attendant process innovation and market introduction so far the new product has been launched in market successfully. Moreover, there is a risk that the commercializing time is not long enough to re-win the previous investment as the life cycle of product has been shorten by the innovation.

illustration not visible in this excerpt

Filter 1 Filter 2 Filter 3 Filter 4

Figure 7: Expectation and chance of successful innovation

Source: A.D.Little 1988, S.113; zitiert nach Haedrich/Tomczak 1996, S.156

Adopted from Meffert, Heribert, Marketing, page 378-379

2.2. Main Challenges in Valuing Product Innovation

Product innovation is a multiple phased process influenced by numerical internal and external factors. Because the internal and external environment of the company changes constantly, the product innovation process is therefore uncertain. There often exist two kinds of risks in product innovation project[19].

One kind of risk concerns the uncertainties associated with the project itself[20]. For example, how will its actual costs compare with estimates? How will performance compare with forecasts?. These are called project risks. Managers and investors can usually avoid such risks by diversifying their investments and hence unexpected losses in one project could be compensated[21]. The other kind of risk stems from external markets and cannot be avoided by the way of diversification[22]. These risks are called market risks. It concerns the uncertainties in the value of the product when it is brought to the market, i.e., there is an uncertain market price for a new product when it starts to be sold. The market risks thus require a higher discount rate as extra compensation, since they are unavoidable[23].

In a product innovation process, managers anticipate and integrate the process at each stage. Through analysing, planning, performing the project, the active management flexibility changes the risks in the product innovation. The decision on the following stage is based on the results of the former stage. The future investment opportunities depend on today’s investment but will only be undertaken contingent on the first investment’s outcome. The following stage is an option

There are many challenges in valuing product innovation:

- Product innovation process is influenced by numerical factors. Many of them are independent. How to identify and qualify these influence and relationships between these factors, which contribute to create value in product innovation process, are difficult.
- Managerial flexibility penetrates in the entire product innovation process. These flexibilities are many “soft factors” which are most difficult to measure.
- Concentration of management flexibility changes from stage to stage in order to achieve different goals on different stage. How to reflect the changes in valuing product innovation is the third challenge.
- As illustrated, a product innovation process is a long-term strategic decision in company. It often takes a few years from beginning the project to the first product test and market launch. In this time horizon the economic environment changes. As a result, management decisions are continuously changed to matching the demand. This raises the question how do we correctly decide the input parameters for measuring the value?

2.3. Selection of the Adequate Methodology

2.2.1. Net Present Value

Net Present Value is one of the major decision criteria based on discounted cash flow analysis which is recommended as the standard tool for project evaluation. The NPV is defined as the sum of the discounted gross operating cash flows over a predefined period of time[24]. It represents an additional market value of the company due to performing the project.

illustration not visible in this excerpt

GOCF = normalized gross operating cash flows

Regarding the capital structure, the weighted average cost of capital (WACC) (after tax) is used by many companies as a discount rate for financed projects. The logic of WACC is that company raises money from two main sources: equity and debt. The capital structure of a company comprises three main components: preferred equity[25], common equity[26] and debt (typically bonds and notes). The WACC takes into account the relative weights of each component of the capital structure and presents the expected cost of new capital for a company.



Rainey, D. “Leading Change through Integrated Product Innovation”

[2] Trigeorgis, L. 1997. Real Options – Managerial Flexibility and Strategy in Resource Allocation, p.151

[3] Cobb, B., and Charnes, J. 2003. “Simulation and Optimization for Real Options Valuation”, p.1

[4] Copeland, T., and Antikarov, V. 2001. Real Options – A Practitioner’s Guide, p.193

[5] Selchert, M., The script for lecture operational consulting I, p. 3-9

[6] Trigeorgis, L. 1997. Real Options – Managerial Flexibility and Strategy in Resource Allocation, p.375

[7] Rainey, D.,Product Innovation: Leading Change through Integrated Product Development (Cambridge

University Press)


[9] Amram, M., and Kulatilaka, N. 1999. Real Options – Managing Strategic Investment in an Uncertain World, p.27

[10] Definition in International Accountant Standard Paragraph 38.

[11] Trigeorgis, L. 1997. Real Options – Managerial Flexibility and Strategy in Resource Allocation, p.121

[12] Müller, J. 2000. Real Option Valuation in Service Industries, p.66

[13] Müller, C. 2002. Productinnovation durch Projectmanagement, p.143

[14] Müller, C. 2002 Productinnovation durch Projectmanagement, p.144

[15] Holt, K. 1988. Product Innovation Management, p.15

[16] Meyer, J.W. 2000. Produktinnovationserfolg und Target Costing , p. 7

[17] Meyer, J.W. 2000. Produktinnovationserfolg und Target Costing , p. 6

[18] Holt, K. 1988. Product Innovation Management, p.6

[19] Neely, J. E. 2001. Hybrid real options valuation of risky product development project, p. 9

[20] Neely, J. E. 2001. Hybrid real options valuation of risky product development project, p.10

[21] Neely, J. E. 2001. Hybrid real options valuation of risky product development project, p.10

[22] Neely, J. E. 2001. Hybrid real options valuation of risky product development project, p.10

[23] Neely, J. E. 2001. Hybrid real options valuation of risky product development project, p.10

[24] Selchert, M. 2003. CFROI of Customer Relationship, p.57

[25] Preferred equity financing, that is senior to sponsor equity, for commercial real estate properties and portfolios with value creation opportunities. This product can resemble a mezzanine loan and be useful when secondary financing is prohibited or can be used for transactions which require an equity partner due

[26] The sum of the value of common stock at par, the surplus of capital received (over par) from the sale of common (i.e., capital surplus), and retained earnings (i.e., earned surplus). Retained earnings in this context equals net profits earned in all years, less dividends paid in all years. to risk profile or deal structure


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Titel: Real Option Valuation of Product Innovation