Real options to expand can be used by young companies or existing companies who are looking to make an investment in new areas. With an expansion option, a company invests in an initial project which allows it the opportunity to invest in future projects or new markets in the future. The first project can be viewed as an option to invest in future projects so there is a price a for such an option. In other words, a company is willing to accept a negative net present value on the first phase because of the possibility of high net present value in the second phase and future phases.

Figure 1. The Option to Expand a Project[1]

A company may decide to use an expand real option when it introduces a new product or service. This move into an “unknown territory” is often done in two phases. The first phase is a smaller-scale investment to introduce the new product or service into one market. If the first phase is successful, the company will then invest on a larger-scale an expand into other markets for greater profit (second phase).

Option: first phase of investment (small-scale)

Underlying asset: second phase of the investment

Premium: the loss on the first phase (cost of investment - expected cash flow)

Strike date: predetermined time when the underlying asset is measured and a decision (to expand or not to expand) is reached

Payoff: profit from the second phase (expected cash flow – cost of investment)

For example, Company A wants to enter a new market, but due to the great uncertainty of the product’s success, is a little wary to make a full-scale investment. To alleviate this problem, Company A could enter into an expansion real option. The company determines that it will cost $100 to invest in the first phase of the option (the $100 acting as a premium). In other words, the cost of entering the new market on a small-scale exceeds the present value of expected cash flows by $100. However, at some predetermined point after the initiation of the first phase, Company A feels that it will have a better idea of whether or not the larger-scale introduction will be successful. Therefore, as the option plays out, Company A is constantly revising expected cash flow from the large-scale investment based on the performance of the option. If by the set “decision” date, or “strike” date, the present value of expected cash flows for a large-scale expansion exceed the cost of large-scale expansion then the company goes ahead with the second phase. If not, Company A experiences relatively small loss, a premium of $100, and moves forward with other investment opportunities.

Brian and Nicole