Real Options and Product Life Cycles
Management Science 45, p.670-684, 1999

Nicolas P.B. Bollen

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.