Product Development and Market Expansion: A Real Options Model

We create a model that values complementary and substitute products with potentially correlated revenues, which must be developed sequentially. The model also incorporates the effects of changing market conditions. We find that the value of a combined project increases in correlation, but the probability of investing in the initial product is a decreasing function of correlation. These results are reversed if the products are substitutes. Regardless of the correlation level, higher levels of substitutability reduce the value of the combined projects and increase the probability of investing. Despite greater uncertainty during the phase of limited competition, the firm is more likely to invest early than to postpone investment. Copyright (c) 2007 Financial Management Association International.