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Managerial flexibility and the wealth effect of new product introductions

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Abstract

This paper examines whether investors recognize the value of managerial flexibilities, as proxied by real options, in their valuation of new product introductions. We define a firm’s real options portfolio as the difference between the firm’s market value and its assets in place. A firm’s strategic flexibilities are modeled as the ratio of its real option portfolio to its book value. Using a sample of new product introductions from 1998–2007, we find our real options measure is positively related to announcement period abnormal returns. This result holds after we control for other variables known to be correlated with the announcement effect in previous studies. Our result is robust to alternative measures of real options based on analysts’ earnings expectations and whether a firm has one or multiple segments. In summary, our results suggest that a firm’s perceived strategic and operating flexibilities are an important factor in the valuation of new products.

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Notes

  1. For example, Kester (1984, 1986) and Pindyck (1988) argue that the fraction of market value attributable to the value of capital in place is less than 50 %, with the remaining contributed by various operating options in face of high demand volatility.

  2. In sensitivity analysis, we relax this assumption and obtain a more accurate real option measure for new products by restricting our sample to single-segment firms. Our inferences remain unchanged.

  3. Assuming the book value of assets approximately equals the book value of the firm’s assets in place, the real-option portfolio as a percentage of the firm’s market value is 2.740/(1 + 2.740) = 73 %.

  4. This result is largely consistent with Pindyck (1988), who suggests that a firm’s capital in place accounts for less than 50 % of its value, and this weight may further decrease with higher volatility in demand for the firm’s product. Using the volatility of a firm’s quarterly sales (weighted by average quarterly sales) over a three-year period prior to the announcement as a proxy for product demand volatility, we find our real option measure is significantly positively associated with demand volatility.

  5. The average firm size is $532.57 million in Chaney et al. (1991), $8,341 million in Chen et al. (2002), and $2,298 million in Kelm et al. (1995).

  6. We examined the variance inflation factors (VIFs) for each of our multivariate regressions and none of the calculated VIFs exceed two, suggesting that multicollinearity is unlikely to be a problem.

  7. The adjusted R2 of the full model is 0.076. The low R2 seems to be a norm in event studies on new product introductions. The explanatory power of our model is comparable to those reported in prior studies. For example, the adjusted R2 in a study by Chaney et al. (1991) is only 0.033, while the model used in Chen et al. (1991) has more explanatory power with an adjusted R2 of 0.087.

  8. For example, IBM simultaneously ran seven business divisions in 2006, namely: (1) software, (2) global financing, (3) system/technology group, (4) global technology service, (5) global business service, (6) others and adjustments, and (7) eliminations. It is obvious that products or services from some divisions (e.g. software) may be significantly different from those from other divisions (e.g. global financing).

  9. Our inferences remain unchanged if we use the alternative measure based on the analysts’ forecasts. The sample size is dramatically reduced as a result of requiring available data from both I/B/E/S and Compustat segment files.

  10. Specifically, an individual firm’s state vector includes three firm specific state variables: mean-adjusted log excess return over the announcement quarter, mean-adjusted log book to market ratio, and mean-adjusted log profitability (proxied by return on equity). We estimate the VAR by industry using one pooled prediction regression per state variable.

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Authors and Affiliations

  1. The State University of New York, Canton, NY, USA

    Chengru Hu

  2. California State University, Fullerton, CA, USA

    Wei Jiang

  3. Rutgers University, New Brunswick, NJ, USA

    Cheng-few Lee

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  1. Chengru Hu
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  2. Wei Jiang
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  3. Cheng-few Lee
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Correspondence to Wei Jiang.

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Hu, C., Jiang, W. & Lee, Cf. Managerial flexibility and the wealth effect of new product introductions. Rev Quant Finan Acc 41, 273–294 (2013). https://doi.org/10.1007/s11156-012-0310-3

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