| 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 typically ignore product life cycle models and specify instead
a constant expected growth rate of 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. |