Optimal Investment Decisions under Product Life Cycle and Market Power: A Real Options Approach
Author
Abstract
This paper employs a real options approach to analyze optimal investment decision. When the investment projects have the characteristics of irreversibility, uncertainty and the option to wait or exit, the traditional Net Present Value (NPV) method would underestimate the value of investment, since it neglects the values of timing and operational flexibility. The distinctive feature of this paper is that the effects of product life cycle as well as market power are incorporated into the model. It is shown that the optimal waiting of the investment is shorter than the American call options model of McDonald and Siegel (1986), which does not incorporate dividend yield in their model. Once product life cycle and market power are incorporated, the optimal waiting of the investment is shorter than the models of McDonald and Siegel (1986). Finally, a numerical method is used to analyze the determinants of optimal investment decision. Our results indicate that the investment-ratio threshold will be higher and thus the optimal entry time of the investment will delay when (1) the product life cycle is longer, (2) the uncertainty is larger, (3) the discount rate is lower, (4) market power is larger and (5) the correlation between cost and revenue is more negative. However, in different types of market demand, the market power is larger and makes investment-ratio threshold smaller (larger) with non-experienced (experienced) goods.
Key Words
Market Power, Product Life Cycle, Real Options Approach, Irreversibility
