The Value of Learning in the Product Development Stage: A Real Options Approach

In this paper we use a real options approach to value pilot project investments that help reduce idiosyncratic uncertainty with respect to the final costs of a project. We develop a general one period investment model and, using standard financial engineering techniques, are able to find the value of these investment opportunities and the corresponding optimal investment level. In our setting, both tradable market uncertainty and idiosyncratic technical uncertainty affect the value of the project, with the latter being driven by the amount invested in the pilot stage. Learning is modeled using a proportionality assumption between investment in the development stage and resolution of technical uncertainty. The coefficient that governs this proportionality relation will play a key role in our model, as it defines whether there are decreasing or increasing marginal returns to investment in the development stage and to what extent. Interesting economic implications concerning the effects of this learning coefficient and other parameters of interest in the optimal investment decision are obtained. The robustness of our results is also analyzed. Finally, applications of our framework to investment decisions in various industries and across the supply chain of firms are discussed. ∗Dept. of Management Science and Engineering, Terman Building Room 477. Email:[email protected]. This work was done under the supervision of Prof. Blake Johnson from Stanford University. The author also wishes to thank James Primbs, John Weyant, Eymen Errais, as well as Scott Mathews from the Boeing Corporation for helpful discussions