ACCA Strategic Professional · Advanced Financial Management · Application of option pricing theory in investment decisions
Zenith plc is considering a project with a negative NPV of $2.0m on a stand-alone basis. The project gives management the right, but not the obligation, to launch a follow-on product in three years if market conditions prove favourable. In real options terminology, this right is best described as which of the following?
It is an option to expand, also called a growth option. Management holds a right, without obligation, to invest further if conditions turn favourable, which behaves like a call option. Its value is added to the stand-alone NPV to give the overall project value.
- AAn option to abandon
- BAn option to delay
- CAn option to expand (growth option)Correct
- DAn option to switch inputs
Explanation
A right to undertake a follow-on investment if conditions are favourable is a call-type option to expand, also called a growth option. An abandonment option is a put-type right to exit; a delay option concerns the timing of the initial investment. The value of the expansion option should be added to the static NPV to get the expanded NPV.
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