Valuating New Product Development Project with a Stochastic Volatility Model

Abstract

In this study, we develop an option-based model to valuate New Product Development (NPD) projects in which management has the flexibility to abandon the project upon completion if the value of the established product falls below the required investment outlay. In the analysis, we explicitly consider the fact that the level of product volatility changes across development stages, as well as the stochastic nature of competition erosion. A closed-form solution is derived under a simplifying assumption of independence between product volatility and other stochastic processes considered in the model. The complete model is solved numerically by using Monte Carlo simulation. Our result indicates that ignoring the stochastic natures of product development uncertainty and competition erosion introduces a severe undervaluation bias. Such a bias worsens when 1) current product value is close to the required investment cost (so that the NPD project is nearly “at-the-money”); 2) development duration lengthens; 3) competition is intense; 4) the window of profitable opportunity lengthens, and 5) the market and the developing firm are more risk-prone (less risk-averse).