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mytechnologycompany.com Why Real Options Matter In Product Development Evaluation
Why Real Options in Technology Product Development <ul><li>Standard methods of financial analysis for new product developm...
Simple Example: NPV <ul><li>Hypothetical Product Development example: </li></ul><ul><ul><li>Development occurs over two ye...
Simple Example: NPV <ul><li>Using a  10% discount rate  </li></ul><ul><ul><li>NPV = - $1.1 MM </li></ul></ul><ul><li>As NP...
Cash Flows Are Not Certain <ul><li>In real world: </li></ul><ul><ul><li>We do not know our revenues to a certainty. </li><...
We Have Options! <ul><li>What if we recognize that we do not have to invest the $30 MM in Yr 1? </li></ul><ul><ul><li>Here...
We Have Options! <ul><li>Furthermore, at Yr 0 we do not have a clear picture of the potential market (i.e., we don’t know ...
We Have Options! <ul><li>Therefore, that $5 MM investment in Yr 0, gives the company 1 year to evaluate the market and tec...
Options Can Be Valued <ul><li>We can map the traditional NPV inputs of the $30 MM option investment and its accompanying r...
Our Option Valuation <ul><li>Using the Black-Scholes formula we discover the option to invest the additional $30 MM to get...
Investment Becomes More Attractive <ul><li>Accounting for the option for further investment and the uncertainty surroundin...
Other Options <ul><li>We can use options in a number of examples. </li></ul><ul><ul><li>Initial investment builds a produc...
Option Analysis Fits Technology <ul><li>Why is Options Analysis a good fit for technology products </li></ul><ul><ul><li>T...
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Options Analysis in Product Development

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Options Analysis in Product Development

  1. 1. mytechnologycompany.com Why Real Options Matter In Product Development Evaluation
  2. 2. Why Real Options in Technology Product Development <ul><li>Standard methods of financial analysis for new product development are ROI or NPV calculations. </li></ul><ul><li>Problem is that these measures fail to account for all the opportunities presented by a fast changing environment. </li></ul><ul><li>Technology development usually presents companies with multiple potential areas to grow their product into. </li></ul>
  3. 3. Simple Example: NPV <ul><li>Hypothetical Product Development example: </li></ul><ul><ul><li>Development occurs over two years </li></ul></ul><ul><ul><li>Forcasted revenue stream starts in yr 2 and continues until end of life at yr 8. </li></ul></ul>0 1 2 $5MM $30MM 3 4 5 6 7 8 $5MM $8MM $10MM $10MM $8MM $5MM $2MM
  4. 4. Simple Example: NPV <ul><li>Using a 10% discount rate </li></ul><ul><ul><li>NPV = - $1.1 MM </li></ul></ul><ul><li>As NPV is negative company will likely not invest in project </li></ul>0 1 2 $5MM $30MM 3 4 5 6 7 8 $5MM $8MM $10MM $10MM $8MM $5MM $2MM 10% Discount Rate
  5. 5. Cash Flows Are Not Certain <ul><li>In real world: </li></ul><ul><ul><li>We do not know our revenues to a certainty. </li></ul></ul><ul><ul><li>We do not have to invest the $30 MM in Yr 1 if the market doesn’t look attractive. </li></ul></ul>0 1 2 $5MM $30MM 3 4 5 6 7 8 $5MM $8MM $10MM $10MM $8MM $5MM $2MM 10% Discount Rate
  6. 6. We Have Options! <ul><li>What if we recognize that we do not have to invest the $30 MM in Yr 1? </li></ul><ul><ul><li>Here, we place a “Go/Kill” decision before we invest the $30 MM. </li></ul></ul><ul><ul><li>Between Yr 0 and the “Go/Kill” decision, we can assume we will do further market research and technology evaluations. </li></ul></ul>0 1 2 $5MM $30MM 3 4 5 6 7 8 Go/Kill Decision 10% Discount Rate $5MM $8MM $10MM $10MM $8MM $5MM $2MM
  7. 7. We Have Options! <ul><li>Furthermore, at Yr 0 we do not have a clear picture of the potential market (i.e., we don’t know what platform will become the standard). </li></ul><ul><li>Let’s assume a 50% volatility for revenues </li></ul><ul><ul><li>This means that each year revenues can be up to 50% more or less than we estimate </li></ul></ul><ul><ul><li>Thus in Yr 4 revenues could be as high as $15 MM or as low as $5 MM. </li></ul></ul>0 1 2 $5MM $30MM 3 4 5 6 7 8 Go/Kill Decision 10% Discount Rate $5MM $8MM $10MM $10MM $8MM $5MM $2MM 50% Volatility
  8. 8. We Have Options! <ul><li>Therefore, that $5 MM investment in Yr 0, gives the company 1 year to evaluate the market and technology. </li></ul><ul><li>It gives them an option to enter the market! </li></ul>0 1 2 $5MM $30MM 3 4 5 6 7 8 Go/Kill Decision 10% Discount Rate $5MM $8MM $10MM $10MM $8MM $5MM $2MM 50% Volatility
  9. 9. Options Can Be Valued <ul><li>We can map the traditional NPV inputs of the $30 MM option investment and its accompanying revenue stream into a Black-Scholes equation </li></ul><ul><ul><li>(S) Present value of a project’s operating assets to be acquired </li></ul></ul><ul><ul><li>(X) Expenditure required to acquire the project’s assets </li></ul></ul><ul><ul><li>(t) Length of time the decision may be deferred </li></ul></ul><ul><ul><li>(r f ) Time value of Money – risk free rate </li></ul></ul><ul><ul><li>(σ 2 ) Riskiness of project assets - volatility </li></ul></ul>
  10. 10. Our Option Valuation <ul><li>Using the Black-Scholes formula we discover the option to invest the additional $30 MM to get the revenue stream is worth $7.2 MM. </li></ul><ul><li>Considering the initial investment the NPV of the project is $2.2 MM. </li></ul><ul><ul><li>Project NPV = -$5 MM + $7.2 MM = $2.2 MM </li></ul></ul>0 1 2 $5MM $30MM 3 4 5 6 7 8 Go/Kill Decision 10% Discount Rate $5MM $8MM $10MM $10MM $8MM $5MM $2MM 50% Volatility
  11. 11. Investment Becomes More Attractive <ul><li>Accounting for the option for further investment and the uncertainty surrounding the market, the company discovers the project would deliver value for the company. </li></ul><ul><li>This is a simple example. We can apply option analysis to a number of complex situation to get a better understanding of the potential value of new development projects. </li></ul>0 1 2 $5MM $30MM 3 4 5 6 7 8 Go/Kill Decision 10% Discount Rate $5MM $8MM $10MM $10MM $8MM $5MM $2MM 50% Volatility
  12. 12. Other Options <ul><li>We can use options in a number of examples. </li></ul><ul><ul><li>Initial investment builds a product that serve as the core for an additional 4 products </li></ul></ul><ul><ul><li>Initial investment allows you to enter one market, but you recognize that it may have potential in enter other markets in a few years </li></ul></ul>
  13. 13. Option Analysis Fits Technology <ul><li>Why is Options Analysis a good fit for technology products </li></ul><ul><ul><li>The rapid rate of technological change </li></ul></ul><ul><ul><li>Technology products can be applied to numerous markets </li></ul></ul><ul><ul><li>Technology products lend themselves to modular designs </li></ul></ul>

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