expansionoptioncannotexceed$2billion,thevalueofthe
expansion option drops to $142 million.
16
Valuing a Firm with the Option to Expand
Isthereanoptiontoexpandembeddedinsomefirmsthatcan
leadtothesefirmstradingatapremiumovertheirdiscounted
cashflowvalues?Atleastintheory,thereisarationalefor
makingthisargumentforasmall,high-growthfirminalarge
andevolvingmarket.Thediscountedcashflowvaluationis
basedonexpectedcashflowsandexpectedgrowth,andthese
expectationsshouldreflecttheprobabilitythatthefirmcould
be hugely successful (or a huge failure). What the
expectations might fail to consider is that in the event of
success the firmcould investmore, add new products, or
expandintonewmarketsandaugmentthissuccess.This is
the real option that is creating the additional value.
Ifthevalueofthisoptiontoexpandisestimated,thevalueof
a firm can be written as the sum of two components—a
discountedcashflowvaluebasedonexpectedcashflowsand
a value associated with the option to expand.
Theoptionpricingapproachaddsrigortothisargument by
estimating the value of the option to expand, and it also
providesinsightintothoseoccasionswhenitismostvaluable.
Ingeneral,theoptiontoexpandisclearlymorevaluablefor
morevolatilebusinesseswithhigherreturnsonprojects(such
as biotechnology or computer software) than in stable