Implications of the Expansion Option

The option to expand is implicitly used by firms to rationalize taking projects that may have negative net present value, but provide significant opportunities to tap into new markets or sell new products. While the option pricing approach adds rigor to this argument by estimating the value of this option, it also provides insight into those occasions when it is most valuable. In general, the option to expand is clearly more valuable for more volatile businesses with higher returns on projects (such as biotechnology or computer software), than in stable businesses with lower returns (such as housing, utilities or automobile production).

It can also be argued that research and development (R&D) provides one immediate application for this methodology. Firms that expend large resources on research and development argue that they do so because it provides them with new products for the future. In recent years, however, more firms have stopped accepting this explanation at face value as a rationale for spending more money on R&D, and have started demanding better returns from their investments.

Research, Development and Test Market Expenses

Firms that spend considerable amounts of money on research and development or test marketing are often stymied when they try to evaluate these expenses, since the payoffs are often in terms of future projects. At the same time, there is the very real possibility that after the money has been spent, the products or projects may turn out not to be viable; consequently, the expenditure is treated as a sunk cost. In fact, it can be argued that R & D has the characteristics of a call option —the amount spent on the R&D is the cost of the call option, and the projects or products that might emerge from the research provide the options. If these products are viable (i.e., the present value of the cash inflows exceeds the needed investment), the payoff is the difference between the two; if not, the project will not be accepted, and the payoff is zero.

Several logical implications emerge from this view of R & D. First, research expenditures should provide much higher value for firms that are in volatile technologies or businesses, since the variance in product or project cash flows is positively correlated with the value of the call option. Thus, Minnesota Mining and Manufacturing (3M), which expends a substantial amount on R&D on basic office products, such as the Post-it pad, generally receives less value for its research than does Intel, whose research primarily concerns semi-conductor chips. Second, the value of research and the optimal amount to be spent on research will change over time as businesses mature. The best example is the pharmaceutical industry - pharmaceutical companies spent most of the 1980s investing substantial amounts in research and earning high returns on new products, as the health care business expanded. In the 1990s, however, as health care costs started leveling off and the business matured, many of these companies found that they were not getting the same payoffs on research and started cutting back.

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