Is it OK to review a paper which builds on my work?
You were probably chosen to be reviewer because it is built on your work and therefore have intensive background knowledge on this topic. As long as you have not worked and do not intend to work on something really similar during the review process you do not have a conflict of interest. 

You should of course try to be objective. Giving a rejection does not have to discourage the authors if you give constructive feedback and make it clear that you find their direction promising.

If you feel like you might not be able to be unbiased you can talk to the editor about it.