Expected Commercial Value for New-Product Project Valuation When High Uncertainty Exists

Abstract

Innovative, bold new-product projects usually have high uncertainties, yet most firms do not handle risk and uncertainty adequately in their financial evaluations. While qualitative factors are usually important in the selection of innovative, higher risk projects, most firms also require some type of financial analysis, the most popular being Net Present Value (NPV). But failing to include risk in NPV calculations yields <italic xmlns:mml="http://www.w3.org/1998/Math/MathML" xmlns:xlink="http://www.w3.org/1999/xlink">very optimistic estimates</i> of the project's financial value, which simply lack credibility. On the other hand, simple risk methods, such as the Probability-adjusted NPV, <italic xmlns:mml="http://www.w3.org/1998/Math/MathML" xmlns:xlink="http://www.w3.org/1999/xlink">consistently undervalue the project</i> which could lead to incorrect kill decisions on innovative projects … a major problem for the firm seeking more transformational new products. Additionally, estimating realistic probabilities of technical and commercial success for the innovative product is a challenge. <p xmlns:mml="http://www.w3.org/1998/Math/MathML" xmlns:xlink="http://www.w3.org/1999/xlink">In this article, the <i>Expected Commercial Value (ECV)</i>, an Options Pricing approach but relatively simple-to-use, is outlined, complete with a true case example. The ECV is a stage-wise model, and thus recognizes that spending decisions for larger new-product projects are incremental, one stage at a time; this mitigates risk, and so <i>increases the economic value of the project</i>, a fact ignored in most financial calculations. The ECV also builds in probabilities of technical and commercial success. <p xmlns:mml="http://www.w3.org/1998/Math/MathML" xmlns:xlink="http://www.w3.org/1999/xlink">The challenge of <i>estimating realistic probabilities</i> of success is handled in two ways: a group prediction process based on the Modified Delphi method; and recently-developed probability tables based on empirical research. The values in the probability tables enable the project team to estimates their odds of success (required in the ECV valuation calculation) based on key characteristics of their project.