Expand or Contract option

In a project such as establishing a manufacturing plant, management often has the option to make a follow-up investment. For example, Gummy Glue Company is evaluating new revolutionary glue. The company can build a plant that is capable of producing 25,000 gallons of glue a month. That level of production is not economical however, either from a manufacturing or from a marketing standpoint. As a result, the projectâ€™s net present value is expected to be a negative \$3 million. According to traditional DCF analysis, the project should be rejected.

However, the new glue could prove to be a winner. If sales were to increase dramatically, Gummy Glue Company could expand the new plant, say, in two years. With the expansion, output would triple, and the plant would be operating at a highly efficient scale. However, the opportunity to accommodate this higher level of demand will not be available unless a first-stage investment is made now. If Gummy Glue does not make the initial investment, the company will not have what business strategists refer to as the first-mover (i.e. first into the market) advantage.

Letâ€™s assume there is a fifty-fifty chance that the market will be much larger in two years. If it is, the net present value of the second-stage investment (expansion) at the end of year 2 will be \$ 15 million. When this value is discounted to the present at the required rate of return, the net present value at time 0 is \$ 11 million. If the market falters over the next two years, the company will not invest further, and the incremental net present value at the end of year 2, by definition, is zero.

The mean of the distribution of possible net present values associated with the option is (0.5) (\$ 11 million) + (0.5) (\$ 0) = \$5.5 million

Project worth = NPV +Option(s) value ——–Equation 1

Using equation 1, we determine the projectâ€™s worth as follows:

Project worth = — \$3.0 million + \$5.5 million
= \$2.5 million.

Although our initial view of the project revealed a negative net present value, we find the option to expand more than offsets the negative NPV. Because the project embraces a valuable option, it should be accepted. For sequential decisions of this sort, a decisions tree approach allows us to analyze subsequent chance events.