Valuation of a new product introduction: A contingent claims approach

This dissertation is motivated by the inherent problems associated with DCF valuation techniques, and in particular, with the valuation of new product introductions. The important limitation of DCF for a new product introduction is that it is not a static valuation problem. Two major valuation problems arise: (1) determination of the appropriate cost of capital and (2) valuation of potential embedded real options. Therefore, valuation of a new product introduction lends itself to contingent claims pricing with a state dependent discount rate.; Two different stochastic models are analyzed. The first is a model in which the sales diffusion process varies stochastically, but the total potential market size is certain. This multiplicative and mean-reverting model allows the incremental sales in any particular period to vary from the expectation for that period. In this model the market size is certain while the timing of cash flows is uncertain. The second is a model in which the potential market size follows a pure random walk, but management has an initial expectation. The resulting market size determines the incremental sales based on the Bass sales diffusion process.; The results of this dissertation show that firms of all risk classifications undervalue new product introductions when employing the traditional DCF valuation methods rather than a correct option based method. In the first model the undervaluation for each of the three firm risk base cases are 15%, 33%, and 52%. In the second model the undervaluation for the base cases are 37%, 19%, and 8% respectively.; These results should help bridge a gap in the literature on the valuation of new product introductions. In academics, this dissertation provides a model which marketing researchers can use to discount correctly uncertain cash flows and finance researchers can correctly value projects which do not rely on the static DCF method. In practice, this helps ensure that profitable rather than unprofitable projects are undertaken and/or that the correct set of projects is undertaken when capital rationing exists. Thus, management can better maximize long-term shareholder wealth.