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.

Answer 1

Option to Expand:

When an organization wants to scale up its operation to increase the bottom line and take advantage of the economy of scale it goes for an expansion decision. But there lies a catch i.e. this decision comes with an investment proposal which is a financial decision to be taken by the organization.

As there will be initial cash outflow so the future benefits have to be analyzed by using financial methods. One of these methods is calculating the NPV of the project for which we need the projected future cash flows and the cost of capital.

Hence this decision comes under capital budgeting as we have to make up our mind whether the project is to be accepted or rejected.

If we get a positive NPV for all the future cash flows and initial cash outflow then the projet of expansion is accepted. If we get NPV zero then it depends on the management to accept or not. But in the case of negative NPV the project is rejected.

If we have multiple projects for expansion and have positive NPV then the timeline, risk factor, fisher's point, sensitivity and scenario analysis are done to make a deceision.