Real Options in New Product Development
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Forecasting valuation of new products is inherently tricky, yet the expected market value of the new product is a key decision for management to approve project work. Research and development (R&D) programs are often designed as a series of investments in order to minimize the risk and uncertainty of innovation. This is the primary theory behind the staged and gated processes used by many firms for New Product Development (NPD).
Intuitively, many NPD practitioners and R&D managers recognize that higher risk projects have the greatest potential for reward. On the other hand, many financial methods favor shorter-term, less risky investments, often referred to as incremental improvements.
Real options can provide a link between the intuition of NPD practitioners with formalized financial assessments. Options are common throughout the financial industry, yet have only recently been integrated into project evaluations. Real options are frequently used in conjunction with decision trees, a more commonly understood process for NPD evaluation.