Question

Typical capital budgeting approaches does not account for the potential value of future expansion opportunities which may become available later in the life of the project. a) Provide an example of an expansion opportunity and discuss how it can be evaluated using the option pricing model. b) What are the parameters of the expansion option (underlying asset, exercise price, variance, risk-free rate, maturity)?

Answer 1

Capital budgeting is the process that companies use for decision making on capital projects with a life of a year or more. Projects susceptible to capital budgeting process can be categorized as

· Replacement,

· Expansion,

· New products and services, and

· Regulatory, safety, and environmental.

Expansion projects are important for the growth of any company. Even if a company simply seeks to expand the production of its current products or broaden its current target market, research and development is required. The ultimate goal for a company embarking on an expansion project is growth and a boost to its bottom line. The expansion opportunity can be defined by the following aspects with example:

1. Launch of New Products: When a company invests in an expansion project, they are typically moving into a new target market or launch of new product. There are several capital investment projects which are designed to help a company expand and grow.

Example :

Mr AB is considering introducing various flavored cookies to the U.S. market. The cookie project will initially be introduced only in the metropolitan areas of the U.S. and the cost of this “limited introduction” is $ 500 million. n A financial analysis of the cash flows from this investment suggests that the present value of the cash flows from this investment to Mr AB will be only $ 400 million.

Thus, by itself, the new investment has a negative NPV of $ 100 million. If the initial introduction works out well, Mr AB could go ahead with a full-scale introduction to the entire market with an additional investment of $ 1 billion any time over the next 5 years.

While the current expectation is that the cash flows from having this investment is only $ 750 million, there is considerable uncertainty about both the potential for the cookie, leading to significant variance in this estimate.

Answer :

1) Value of the Underlying Asset (S) = PV of Cash Flows from Expansion to entire U.S. market, if done now =$ 750 Million

2) Strike Price (K) = Cost of Expansion into entire U.S market = $ 1000 Million

3) We estimate the standard deviation in the estimate of the project value by using the annualized standard deviation in firm value of publicly traded firms in the beverage markets, which is approximately 34.25%.

4) Standard Deviation in Underlying Asset’s Value = 34.25% n Time to expiration = Period for which expansion option applies = 5 years

5) Therefore , Call Value= $ 234 Million

6) NPV of Limited Introduction = $ 400 Million - $ 500 Million = - $ 100 Million

7) Value of Option to Expand to full market= $ 234 Million

8) NPV of Project with option to expand = - $ 100 million + $ 234 million = $ 134 million

9) Decision : Invest in the project

2. Penetrate in to New Market: It is the most successful strategy in any business by reaching out at various target market. The more new market targeted, the probability to get the success of the project is high.

Let’s assume that a company that produces medicines for certain illnesses decides to research, develop, produce, and sell a vaccines that targets a completely different type of disease or illness. The company’s executive staff – and potentially its board of directors – would need to request and review detailed financial analysis of what the shift could mean for the company. If the results show that the expansion into the new target market should prove profitable, then the company will generally work towards growth by expanding into the new market, producing a new vaccines.

3. Increase Sales in current Market:

The most common way to increase sales is to sell more of the existing products. To obtain this target, the company need to expand its current market reach so that it can sell or serve to maximum number of customers. There are several ways you can do this. After the required research and analysis of the numbers one can take decision.

For example:

1. Increase how much the existing customers buy from the company

2 Increasing the number of first-time buyers