The option value of developing two product standards simultaneously when the final standard is uncertain

Onno Lint, and Enrico Pennings, Vlerick Leuven Gent Management School

1/01/2005
(Original Publish Date: 4/22/2002)

This paper presents a framework for valuing managerial flexibility within the context of product standardization. The framework originates in a major standardization problem concerning digital tape recording at Philips Electronics. We use insights from financial option theory to calculate the option value of simultaneously developing two correlated product standards, and then compare this value to the option value of developing a single standard. We determine a threshold level such that for lower follow-on investment outlays development of both standards is optimal while for higher investment levels development of a single standard is optimal. This threshold is negatively related to the correlation between the value of the two standards. Finally, we show that properly incorporating uncertainty and the interdependence between the payoffs to the two standards leads to significantly different conclusions from standard NPV-analysis.