In Search of Corporate Risk Measures to Complete Financial Reporting: The Case of the 'Caldarerie' - Industry

Abstract

This research examines how the decision of when to introduce a new product is affected by uncertainty about values of introducing the product, uncertain and growing investment costs, and existence of a follow-on product. It shows this decision is equivalent to deciding when to exercise a perpetual call option when investment costs are constant and equivalent to deciding when to exercise a perpetual exchange option when investment costs are growing. The research shows that when the return shortfall for the value of introducing the product is greater than the return shortfall for the investment costs an immediate decision should be made when there is certainty and should not be made when there is uncertainty. This research shows that when a follow-on product exists the firm will optimally defer introduction of the initial product for a shorter amount of time and may make initial investments with NPVs that are negative. Keywords: Real Options, Exchange Options, Valuation, Capital Budgeting JEL Classifications: G12, G31Real options analysis (Copeland and Antikarov (2004); McDonald (2006); Mun (2002); Shockley (2007); and Trigeorgis (1998)) can be used to determine when a business firm should enter a market and introduce a new product. The goal of this research is to understand the economic costs and benefits of delaying and timing the introduction of the new product optimally. The introduction of a new product is similar to the exercise of a financial option. The new product has a value that can be obtained by paying the investment costs to provide the required production capacity. The problem of deciding when to introduce a new product is equivalent to the problem of deciding when to exercise an option. By paying the initial investment costs, the owner of the option can receive the value resulting from entering the market. The initial investment costs are the exercise price and the value resulting from entering the market is the value of the underlying asset. For a financial option, early exercise involves a trade-off between dividends lost and interest saved by delaying exercise. Introduction of the new product should be delayed as long as the benefit from delaying exceeds the cost from delaying. The optimal time to introduce the new product maximizes the net present value now of introducing the new product at a future time.Real options analysis of when to introduce a new product is more complicated when the initial investment costs required introducing the new product change over time. Technological progress may cause the initial investment costs to decrease and inflation may cause the initial investment costs to increase. This research shows that an increase in the initial investment costs will cause the new product to be introduced sooner and a decrease in the initial investment costs will cause the new product to be introduced later. The benefit from delaying the investment is smaller when the initial investment costs increase over time and some of the value resulting from delaying the introduction of ...

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