Strategic Investment Decisions for Product Development Projects - An Option-Game Approach

Abstract

Gate-criteria have been identified as critical drivers of the success of a new product development (NPD) process. However, a major weakness of NPD projects is that gate-criteria are often inadequate for making go/kill decisions. The most commonly used financial gate-criterion, the net present value (NPV) method, is insufficient when a project involves uncertainty. Alternatively, the real-option valuation method is also inadequate when a strategic decision involves the actions of competitors. In this research, I first develop an option-game valuation framework that explicitly incorporates product diffusion when dealing with an American investment option in a finite project life. The results of both simultaneous and sequential investment decisions are considered in each scenario of a duopolistic game. I introduce this approach as a gate-criterion to evaluate a new product development project in a fast-paced industry while considering potential managerial flexibility and market competition. As an option-game approach provides the possibility of a go/wait decision, the decision to delay represents an additional resource of value. Secondly, I further develop the option-game valuation framework with Bayesian analysis by explicitly involving technical risk and the 3-player-game in an NPD project. Volatilities from the initially uncertain market can be diminished as decision makers get to know more about customer requirements and preferences, while uncertainties about technical requirements are reduced through updated information about product performance. In addition, the option-game mechanism includes (inverse) measures of product differentiation to describe whether two goods are homogeneous, substituted, or independent, and to what degree. Moreover, the distribution of product correction is used to describe the level of the additional correction costs in a project. I introduce this approach as a gate-criterion to evaluate a new project at the gate and sub-gates of the development stages in the NPD process. The results present important implications: when demand is high, the project initiates “go” action if at least one competitor has a high unit variable cost in competing with a highly comparable product or simply if the target market is highly uncertain. When demand is low, the project may take “go” action only if the firm has a cost advantage. By using these models, industry players can make strategic decisions in a project assessment at the decision points of the development stages.