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THE OPTION TO EXPAND

Notice that MacCaugh`s expenditure on the pilot program buys a valuable managerial option. The firm has the option to produce the new product depending on the outcome of the tests. If the pilot program turns up disappointing results, the firm can walk away from the project without incurring additional costs.

The option to walk away once the results are revealed introduces a valuable asymmetry. Good outcomes can be exploited, while bad outcomes can be limited by canceling the project.

MacCaugh was not obliged to have a pilot program. Instead, it could have gone directly into full-scale whiskey production. After all, if diet whiskey is a success, the sooner MacCaugh can clean up the market the better. But it is possible that the product will not take off; in that case the expenditure on the pilot operation may help the firm avoid a costly mistake. When it proposed a pilot project, MacCaugh`s management was simply following the fundamental rule of swimmers: If you know the water temperature (and depth), dive in; if you don`t, try putting a toe in first.

Here is another example of an apparently unprofitable investment that has value because of the flexibility it gives to make further follow-on investments. Some of the world`s largest oil reserves are found in the tar sands of Athabasca, Canada. Unfortunately, the cost of extracting oil from the sands is substantially higher than the current market price and almost certainly higher than most people`s estimate of the likely price in the future. Yet oil companies have been prepared to pay considerable sums for these tracts of barren land. Why?

The answer is that ownership of these tracts gives the companies an option. They are not obliged to extract the oil. If oil prices remain below the cost of extraction, the Athabasca sands will remain undeveloped. But if prices do rise above the cost of extraction, those land purchases could prove very profitable.

Notice that the option to develop the tar sands is valuable because the future price of oil is uncertain. If we knew that oil prices would remain at their current level, nobody would pay a cent for the tar sands. It is the possibility that oil prices may fluctuate sharply above or below their present level that gives the option value.5

As a general rule, flexibility is most valuable when the future is most uncertain. The ability to change course as events develop and new information becomes available is most valuable when it is hard to predict with confidence what the best action ultimately will turn out to be.

You can probably think of many other investments that take on added value because of the further opportunities that they may open up. For example, when designing a factory, it may make sense to provide for the possibility in the future of an additional production line; when building a four-lane highway, it may pay to build six-lane bridges so that the road can be converted later to six lanes if traffic volume turns out to be higher than expected.

ABANDONMENT OPTIONS

If the option to expand has value, what about the option to bail out? Projects don`t just go on until the equipment disintegrates. The decision to terminate a project is usuallytaken by management, not by nature. Once the project is no longer profitable, the company will cut its losses and exercise its option to abandon the project.

Some assets are easier to bail out of than others. Tangible assets are usually easier to sell than intangible ones. It helps to have active secondhand markets, which really exist only for standardized, widely used items. Real estate, airplanes, trucks, and certain machine tools are likely to be relatively easy to sell. On the other hand, the knowledge accumulated

by a drug company`s research and development program is a specialized intangible asset and probably would not have significant abandonment value. Some assets, such as old mattresses, even have negative abandonment value; you have to pay to get rid of them. It is very costly to decommission nuclear power plants or to reclaim land that has been strip- mined. Managers recognize the option to abandon when they make the initial investment.

Abandonment Option

Suppose that the Wigeon Company must choose between two technologies for the manufacture of a new product, a Wankel engine outboard motor:

1. Technology A uses custom-designed machinery to produce the complex shapes required for Wankel engines at low cost. But if the Wankel engine doesn`t sell, this equipment will be worthless.

2. Technology B uses standard machine tools. Labor costs are much higher, but the tools can easily be sold if the motor doesn`t sell.

Technology A looks better in an NPV analysis of the new product, because it was designed to have the lowest possible cost at the planned production volume. Yet you can sense the advantage of technology B`s flexibility if you are unsure whether the new outboard will sink or swim in the marketplace.

When you are unsure about the success of a venture, you may wish to choose a flexible technology with a good resale market to preserve the option to abandon the project at low cost.