Valuing investment projects with expansion options

PurposeThis article proposes an evaluation of capital investments that accounts for not only the initial assets, but also any potential growth options.Design/methodology/approachUsing a piecewise linear approximation, a robust valuation technique is demonstrated for analyzing capital investment opportunities containing expansion options in a finite time horizon.FindingsThis process not only recognizes the option‐like characteristics of the initial investment opportunity, but also recognizes the option‐creating characteristics of the investment. This analysis shows that the value of capacity expansion options created by the initial investment has different dynamic characteristics from the assets in place. Although the growth options do not appear in the early investment premium, its impact on the investment decision is embedded in the investment threshold. When the time to expiration is short and the cost to delaying the assets in place is low, this analysis suggests that the initial investment decision might be made by ignoring the growth options.Originality/valueThis real option methodology provides a continuous solution to the optimal investment threshold and is a viable alternative to the traditional finite difference approach.