If a company accepts a project that performs better than expected it may decide to expand. It is important to take the Option to Expand into consideration when calculating the net present value (NPV) of a project.
Imagine an entrepreneur wanted to start a new fast food restaurant. The initial cost to get this restaurant started is $1,000,000 and the Cash Flow s thereafter would be perpetual. After extensive research he came up with both an optimistic and pessimistic outlook both having a probability of 50%. He wanted to calculate the NPV of the project with a Discount rate of 25%.
Optimistic forecast: -$1,000,000 + $600,000/.25 = $1,400,000
Pessimistic forecast: -$1,000,000 - $300,000/.25 = -$2,200,000
Now if he weighs both scenarios to calculate an overall NPV he gets an NPV of -$400,000
He should reject the project right? Maybe not. We should dig further.
What if he decided to expand by opening 10 more restaurants if the first restaurant was a success? Now we need to take the expansion into consideration when calculating the NPV of the optimistic forecast.
[.50 x (10 x $1,400,000)] + [.50 x (-$2,200,000)] = $5,900,000 NPV so he should accept the project.