project.Itisthesecondprojectthatrepresentstheunderlying
asset for the option. The inputs have to be defined
accordingly.
- Thepresentvalueof thecash flowsthatwe would
generateifwewere toinvestinthesecondproject
today (the expansion option) is the value of the
underlying asset—Sin the option pricing model. - Ifthereissubstantialuncertaintyabouttheexpansion
potential,thepresentvalueislikelytobevolatileand
changeovertimeascircumstanceschange.Itisthe
varianceinthispresentvaluethatwewouldwantto
usetovaluetheexpansionoption.Sinceprojectsare
nottraded,wehavetoeither estimatethisvariance
from simulations or use the variance in values of
publicly traded firms in the business. - Thecostthatwewouldincurupfront,ifweinvestin
theexpansiontoday,istheequivalent ofthestrike
price. - The life of the optionis fairly difficult to define,
sincethereisusuallynoexternallyimposedexercise
period.(Thisisincontrasttothepatentswevaluedin
theprecedingsection,whichhavealegallifethatcan
beusedastheoptionlife.)Whenvaluingtheoption
toexpand,thelifeoftheoptionwillbeaninternal
constraintimposedbythefirmonitself.Forinstance,
afirmthatinvestsonasmallscaleinChinamight
imposeaconstraintthatitwilleitherexpandwithin
fiveyearsorpulloutofthemarket.Whymightitdo
so?Theremaybeconsiderablecostsassociatedwith
maintainingthesmallpresence,orthefirmmayhave
scarce resources that have to be committed
elsewhere.