The Options to Expand and to Abandon: Valuation Implications
The preceding chapter noted that traditional discounted cash flow valuation does not consider the value of the option that many firms have to delay making an investment, and consequently understates the value of these investments. This chapter considers two other options that are often embedded in investments (and consequently in the values of the firms that possess them). The first of these is the option to expand an investment not only in new markets but to new products, to take advantage of favorable conditions. We argue that this option may sometimes make young start-up firms significantly more valuable than the present value of their expected cash flows. The second option is the option to abandon or scale down investments, which can reduce the risk and downside from large investments and therefore make them more valuable.
THE OPTION TO EXPAND
Firms sometimes invest in projects because the investments allow them either to make further investments or to enter other markets in the future. In such cases, we can view the initial projects as yielding options allowing the firm to invest in other projects, and these options have value. Put another way, a firm may accept a negative net present value on the initial project because of the possibility of high positive net present values on future projects.
Payoff on the Option to Expand
The option to expand can be evaluated at the time the initial project is analyzed. ...