ACCA AFM Syllabus B. Advanced Investment Appraisal - Option to expand - Notes ^{7 / 7}

The option to expand exists when firms invest in projects which allow them to make further investments in the future or to enter new market.

The initial project may be found in terms of its NPV as not worth undertaking.

However, when the option to expand is taken account, the NPV may become positive and the project worthwhile.

Expansion will normally require additional investment creating a call option.

The option will be exercised only when the present value from the expansion is higher than the extra investment.

Illustration

Cow plc has investigated the opening of a new restaurant in UK. 

The initial capital expenditure is estimated at £16 million, whilst the present value of the net cash inflows is expected to be £16.005 million.

If this first restaurant is opened, Cow plc would gain the right, but not the obligation to open a second restaurant in four years time at a capital cost of £22 million.

The present value of the associated future net cash inflows is estimated at £18 million, with a standard deviation of 30%.

If the risk free rate of interest is 3%, determine whether to proceed with the restaurant projects.

Solution

1. Calculate NPV

   Net Present Value = £16.005 - £16 = £0.005

   Since the resulting NPV of £0.005 million is a very small positive amount, this appraisal suggests that the project is extremely marginal.

2. Identify variables:

   Current price (Pa) = $18m
   Exercise price (Pe) = $22m
   Exercise date = 4 years
   Risk free rate = 3%
   Volatility = 30%

Overall value of the project = $0.05m  + $3.71 = -$3.76m