An embedded option that allows the firm which purchased the real option to expand its operations in the future at little or no cost. An expansion option, unlike typical options which obtain their value from an underlying security, receives its worth from the flexibility it provides to a company. Once the initial stage of a capital project has been implemented, an expansion option holder can decide whether to move forward with the project.
In terms of real estate, expansion options provide tenants with the choice to add more space to their living premises.
For example, if a company is unsure as to whether or not its newly introduced product will be successful in the market, it can purchase an expansion option. The expansion option will allow the firm to assess the economic environment in the future and determine whether it is profitable to continue developing the particular product. If the firm initially expected to produce 1,000 units five years, exercising the expansion option would let them purchase additional equipment to increase capacity for a price which is below market value. If economic conditions are good and expansion is desirable, the option will be exercised. Otherwise, the expansion option expires.