Question

Within capital budgeting decisions, there are three ‘hidden’ options; option to expand, option to abandon and timing options. Select one of these options and explain the option in detail with real world example.

Answer 1

An option to expand is an embedded option that allows the firm that purchased a real option ( a right to undertake certain actions) to expand its operations in the future at little or no cost. Option to expand receives its worth from the flexibility it provides to a company. After the implementation of initial stage of the project, an expansion option holder can decide whether to go ahead with the project.

For example, in a project of introducing a product, the expansion option will allow the firm to consider the economic environment in the future and determine whether it will be profitable to continue developing the product. The exercising of option would let the company purchase additional equipment to increase capacity for a price, which is lower than its market value. If economic conditions are favorable and expansion is desirable, the option can be exercised. Otherwise, the expansion option holder can let expire the option.