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Valuing Modularity as a Real Option

School of Business, George Washington University, Washington, DC 20052; and Department of Economics, University of Verona, 37129 Verona, Italy
University of Lugano, 6900 Lugano, Switzerland; and Swiss Finance Institute, 1211 Geneva, Switzerland
agamba{at}gwu.edu
nicola.fusari{at}usi.ch

We provide a general valuation approach for capital budgeting decisions involving the modularization in the design of a system. Within the framework developed by Baldwin and Clark (Baldwin, C. Y., K. B. Clark. 2000. Design Rules: The Power of Modularity. MIT Press, Cambridge, MA), we implement a valuation approach using a numerical procedure based on the least-squares Monte Carlo method proposed by Longstaff and Schwartz (Longstaff, F. A., E. S. Schwartz. 2001. Valuing American options by simulation: A simple least-squares approach. Rev. Financial Stud. 14(1) 113–147). The approach is accurate, general, and flexible.

Key Words: real options; modularity; least-squares Monte Carlo
History: Received: April 6, 2008; accepted: June 27, 2009.