L10 - Option to Expand and Abandon

Week 11 valuation of the option to expand the option

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Week 11: Valuation of the Option to Expand, the Option to Abandon, and Firms in Distress 4 When are expansion options valuable? To justify an investment in a –ve NPV project with an option to expand, management must establish the presence of such an option ( qualitative argument) and quantify that the option to expand earns an excess returns with economic benefits that exceed the costs incurred by the seed investment, i.e. option value + ( ve NPV) > 0. Qualitative test/argument: i) Is the 1 st investment a pre requisite for the expansion? Investments in R&D and exploration are clearly needed to generate patents and to discover natural resources However, the need for Ambev to invest in the U.S. metro area first to gain information about market potential before the subsequent expansion to the rest of the U.S. is doubtful ii) Does the 1 st investment give the firm an exclusive right to the expansion? If not, does the 1 st investment give the firm significant competitive advantages on the expansion? Greater competitive advantages are associated with larger excess returns and larger option values. iii) Is the competitive advantage or excess return sustainable? Ambev’s seed investment to introduce Guavana to the U.S. may not necessarily give the expansion any sustainable competitive advantages. If it provides market information to competitors like Coke and Pepsi instead to introduce similar drinks at the same time as the subsequent expansion, there is no value in the option to expand. If the seed investment gives Ambev a lead time to earn excess returns, thenEither allow for higher CFs for that lead time and lower CFs thereafter to reflect the erosion of market share OR reduce and cap the PV of the cash flows from the expansion option
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