Expected Commercial Value for New-Product Project Valuation When High Uncertainty Exists

Innovative and bold new-product projects usually have high uncertainties, yet most firms do not handle risk and uncertainty adequately in their financial evaluations. Although qualitative factors are usually important in the selection of innovative and higher risk projects, most firms also require some type of financial analysis, with the most popular being net present value (NPV). However, failing to include risk in NPV calculations yields very optimistic estimates of the project's financial value, which simply lack credibility. On the other hand, simple risk methods, such as the probability-adjusted NPV, consistently undervalue the project, which could lead to incorrect kill decisions on innovative projectsa major problem for the firm seeking more transformational new products. Additionally, estimating realistic probabilities of technical and commercial success for the innovative product is a challenge. In this article, the expected commercial value (ECV), an options pricing approach that is relatively simple to use, is outlined, complete with a true case example. The ECV is a stagewise model and thus recognizes that spending decisions for larger new-product projects are incremental, one stage at a time; this mitigates risk and so increases the economic value of the project, a fact ignored in most financial calculations. The ECV also builds in probabilities of technical and commercial success. The challenge of estimating realistic probabilities of success is handled in two ways: a group prediction process based on the modified Delphi method, and recently developed probability tables based on empirical research. The values in the probability tables enable the project team to estimate their odds of success (required in the ECV valuation calculation) based on key characteristics of their project.