Assume that Disney is considering investing $ 100 million to create a Spanish version of the Disney channel to serve the growing Mexican market. Assume, also, that a financial analysis of the cash flows from this investment suggests that the present value of the cash flows from this investment to Disney will be only $ 80 million. Thus, by itself, the new channel has a negative NPV of $ 20 million.
One factor that does have to be considered in this analysis is that if the market in Mexico turns out to be more lucrative than currently anticipated, Disney could expand its reach to all of Latin America with an additional investment of $ 150 million any time over the next 10 years. While the current expectation is that the cash flows from having a Disney channel in Latin America is only $ 100 million, there is considerable uncertainty about both the potential for such an channel and the shape of the market itself, leading to significant variance in this estimate.
The value of the option to expand can now be estimated, by defining the inputs to the option pricing model as follows:
Value of the Underlying Asset (S) = PV of Cash Flows from Expansion to Latin America, if done now =$ 100 Million
Strike Price (K) = Cost of Expansion into Latin American = $ 150 Million
We estimate the variance in the estimate of the project value by using the annualized variance in firm value of publicly traded entertainment firms in the Latin American markets, which is approximately 10%.
Variance in Underlying Assets Value = 0.10
Time to expiration = Period for which expansion option applies = 10 years
There is no cost of delay.
Assume that the ten-year riskless rate is 6.5%. The value of the option can be estimated as follows:
Call Value= 100 (0.7915) -150 (exp(-0.065)(10) (0.3400)= $ 52.5 Million
This value can be added on to the net present value of the original investment in Mexico, which has a negative NPV of $ 20 Million.
NPV of Disney Channel in Mexico = $ 80 Million - $ 100 Million = - $ 20 Million
Value of Option to Expand = $ 52.5 Million
NPV of Project with option to expand = - $ 20 million + $ 52.5 million
= $ 32.5 million
Disney should invest in the Mexican project because the option to expand into the Latin American market more than compensates for the negative net present value of the Mexican project.