Analysing New Product Development Projects Incorporating Real Options: A Basic Model and Case Study

Abstract

This study explores the implementation of Real option analysis (ROA) theory in valuing New Product Development (NPD) projects. A literature survey conducted as part of the research process revealed that traditional Discounted Cash Flow (DCF) techniques used in valuing investments are deterministic and assume that all future outcomes are fixed. However there is always uncertainty and fluctuation in the business environment that would change the initially perceived value of a project. Managerial flexibility is therefore needed to influence and gain maximum value from a potential investment. ROA can mitigate some of the problems of traditional DCF models and provide a comprehensive view of the potential investment`s value and future potential. A combined DCF and ROA model was identified and validated through a case study. The case study analyzed the investment in the development of a roof support product used in the South African underground mining environment. A 7-year period consisting of the initial development phase of the product along with investment required in creating production capacity as well as 5 years of forecasted sales was analyzed. A scenario analysis was conducted as part of the simulation research method wherein uncertainties that could influence the investment`s decision were analyzed and decisional criteria prescribed for each scenario. This study concluded that ROA together with existing DCF models could improve the valuation and decision making process of investing in NPD projects.