Description:
This paper develops a model that values complementary and substitute projects, with potentially correlated revenues, that must be developed sequentially. The problem can be thought of as a sequential development of two simple projects with an option to exchange. The initial project has limited direct value because it is assumed that competition limits its direct cash flows. There is however an indirect benefit from the lead project in that its implementation is necessary before investment in a follow-on high value project can be undertaken. The follow-on project has significant value because there is a period of limited competition (ensured for instance by a patent).Whether the products are partial substitutes or complements, we find that the value of the combined projects and the time value of the option to invest in the initial project are increasing functions of correlation, and the probability of investing in the initial product is a decreasing function. If the products are substitutes, correlation can have a negative impact on the value of the combined projects and the time value of the option to invest in the initial project. The effect of correlation increases when the value of the initial product is relatively more uncertain. Moreover, the lower the correlation between the products, the higher the likelihood that the optimal timing for investing in the follow-on product is separated from that of the initial product. Regardless of the level of correlation, a higher degree of substitutability increases the value of the combined projects but reduces the time value of the option to invest in the initial one, thus increasing the probability of investing. Finally, we show that despite greater uncertainty during the phase of limited competition, the firm is more likely to invest earlier