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

Real option

A real option gives a firm's management the right, but not the obligation to undertake certain business opportunities or investments.Real option refer to projects involving tangible assets versus financial instruments.Real options can include the decision to expand, defer or wait, or abandon a project entirely.

• Expansion option

The option to expand is often imbedded in investment projects. The value of follow-on investments can be significant and in some case even trigger the project to have positive NPV.

• Timing option

An investment opportunity with positive NPV does not mean that we should go ahead today. In particular if we can delay the investment decision we have an option to wait. The optimal timing is a trade-off between cash flows today and cash flows in the future.

• Abandonment option

Traditional capital budgeting assumes that a project will operate in each year during its lifetime. However, in reality firms may have the option to cease a project during its life. An option to abandon a project is valuable: If bad news arrives you will exercise the option to abandon the project if the value recovered from the project's assets is greater than the present value of continuing the project. Abandonment options can usually be evaluated using the binominal method.

Expansion option in detail:

The option to expand is often imbedded in investment projects. The value of follow-on investments can be significant and in some case even trigger the project to have positive NPV.

Examples of options to expand:

- Provide extra land and space for a second production line when designing a production facility.

- A pharmaceutical company acquiring a patent that gives the right, but not the obligation to market a new drug.

- Building 6-lane bridges when building a 4-lane highway.

Real world example

The McDonald's corporation has restaurants in more than 100 countries . They decided to start additional restaurants in Russia.This fall under the real option to expand.