The second type of growth option allows a company to expand into new geographic
markets. Many companies are investing in Eastern Europe, Russia, and China even
though standard NPV analysis produces negative NPVs. However, if these developing
markets really take off, the option to open more facilities could be quite valuable.
The third type of growth option is the opportunity to add new products, including
complementary products and successive “generations” of the original product.
Toshiba probably lost money on its first laptop computers, but the manufacturing
skills and consumer recognition it gained helped turn subsequent generations of lap-
tops into money makers. In addition, Toshiba used its experience and name recogni-
tion in laptops as a springboard into the desktop computer market.Abandonment Options
Many projects contain an abandonment option. When evaluating a potential project,
standard DCF analysis assumes that the assets will be used over a specified economic
life. While some projects must be operated over their full economic life, even though
market conditions might deteriorate and cause lower than expected cash flows, others
can be abandoned. For example, some contracts between automobile manufacturers
and their suppliers specify the quantity and price of the parts that must be delivered. If
the supplier’s labor costs increase, then the supplier might well lose money on each part
it ships. Including the option to abandon in such a contract might be quite valuable.
Note too that some projects can be structured so that they provide the option to
reduce capacity or temporarily suspend operations. Such options are common in the natural
resource industry, including mining, oil, and timber, and they should be reflected in
the analysis when NPVs are being estimated.Flexibility Options
Many projects offer flexibility options that permit the firm to alter operations depend-
ing on how conditions change during the life of the project. Typically, either inputs or
outputs (or both) can be changed. BMW’s Spartanburg, South Carolina, auto assembly
plant provides a good example of output flexibility. BMW needed the plant to produce
sports coupes. If it built the plant configured to produce only these vehicles, the con-
struction cost would be minimized. However, the company thought that later on it
might want to switch production to some other vehicle type, and that would be difficult
if the plant were designed just for coupes. Therefore, BMW decided to spend additional
funds to construct a more flexible plant—one that could produce different types of vehi-
cles should demand patterns shift. Sure enough, things did change. Demand for coupes
dropped a bit and that for sports utility vehicles soared. But BMW was ready, and the
Spartanburg plant is now spewing out hot-selling SUVs. The plant’s cash flows are
much higher than they would have been without the flexibility option that BMW
“bought” by paying more to build a more flexible plant.
Electric power plants provide an example of input flexibility. Utilities can build
plants that generate electricity by burning coal, oil, or natural gas. The prices of those
fuels change over time, depending on events in the Middle East, changing environ-
mental policies, and weather conditions. Some years ago, virtually all power plants
were designed to burn just one type of fuel, because this resulted in the lowest con-
struction cost. However, as fuel cost volatility increased, power companies began to
build higher-cost but more flexible plants, especially ones that could switch from oil to
gas and back again, depending on relative fuel prices.Name some different types of real options.636 CHAPTER 17 Option Pricing with Applications to Real Options