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What Is an Expansion Option?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 23 November 2016
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    Conjecture Corporation
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An expansion option is a type of investment that can be secured to aid businesses in taking advantage of expansion opportunities which may arise in connection with a given project. The idea behind the option is to help offset the costs associated with choosing to move forward with that expansion at a rate that was not previously forecast. This approach can be utilized in a number of situations ranging from expanding the rate of production of a new product that generated a much higher demand than originally envisioned to allowing tenants the ability to expand the size of a store or other retail setting with relative ease if the business volume justifies the action.

Securing an expansion option usually occurs at the time the real option associated with the venture is purchased. This type of embedded option remains in place for the life of that real option, and can be called upon when needed. While adding on the expansion option does often cost a little more, the extra expense is usually low enough to not cause hardship for the buyer, and does have the ability to provide significant returns if the investor ever calls the option.

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One of the easiest ways to understand how an expansion option works is to consider a small business owner who opens a retail location on a given city block. As part of the arrangement, the owner secures an expansion option that can be invoked if the business generates considerably more business volume during that first year of operation than originally anticipated. The option can then be exercised to help the owner secure additional equipment and other necessities that can be used to expand the location, allowing the business to accommodate additional stock and hopefully continue to increase the number of sales generated each month.

In like manner, the expansion option can also be utilized by a company that is launching a new product. By having the option in place, the business is able to secure additional raw materials or even more production equipment if the demand for that new product exceeds a certain level, making it necessary to expand the production facilities in order to keep up with that demand. Without having this type of option in place, the cost of expansion could be somewhat prohibitive, prompting the company to delay the expansion and losing potential sales as a result. As a means of hedging on a new opportunity, the expansion option positions the holder to take advantage of opportunities to expand a project beyond the original plans and ultimately generate considerably more profit from the activity while also keeping expenses as low as possible.

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