Abandonment Option
An abandonment option refers to the right of a company to discontinue a project or investment if it becomes unprofitable or no longer aligns with its strategic objectives. This option provides flexibility and risk management for businesses, allowing them to cut their losses and reallocate resources to more promising opportunities. The decision to exercise the abandonment option is typically based on a cost-benefit analysis.
2 Key excerpts on "Abandonment Option"
eBook - ePubInvestment Valuation
Tools and Techniques for Determining the Value of any Asset, University Edition
- Aswath Damodaran(Author)
- 2012(Publication Date)
- Wiley(Publisher)
...In such cases, it would not make sense to abandon unless the cash flows on the project are even more negative. Extensions and Implications of Abandonment Options The fact that the option to abandon has value provides a rationale for firms to build the operating flexibility to scale back or terminate projects if they do not measure up to expectations. It also indicates that firms that try to generate more revenues by offering their customers the option to walk away from commitments will have to weigh the higher revenues against the cost of the options that have been granted to these customers. Escape Clauses in Contracts The first and most direct way of creating an Abandonment Option is to build operating flexibility contractually with other parties that are involved in a project. Thus contracts with suppliers may be written on an annual basis rather than be long-term, and employees may be hired on a temporary basis rather than permanently. The physical plant used for a project may be leased on a short-term basis rather than bought, and the financial investment may be made in stages rather than as an initial lump sum. While there is a cost to building in this flexibility, the gains may be much larger, especially in volatile businesses. Customer Incentives On the other side of the transaction, offering Abandonment Options to customers and partners in joint ventures can have a negative impact on value. As an example, assume that a firm that sells its products on multiyear contracts offers customers the option to cancel the contract at any time. While this may increase sales, there is likely to be a substantial cost. In the event of a recession, customers that are unable to meet their obligations are likely to cancel their contracts...
eBook - ePub- David Heller, David Heller(Authors)
- 2019(Publication Date)
- Wiley-ISTE(Publisher)
...The uncertainty of decisions to invest in joint ventures or alliances encourages Damaraju et al. (2015) to integrate the presence of options in the choices of corporate governance modes. For example, divestment is similar to exercising the sale of a put option. Here again, companies are encouraged to wait until they have enough information before deciding on a possible abandonment. In the natural resources sector, production is subject to uncertainty. The integration of real-option-based models, such as that of Brennan and Schwartz (1985), makes it possible to define policies that optimize the decision to invest by retaining the effects of time, costs, and convenience yield, i.e. the profit a producer derives from his/her stocks. Siegel et al. (1985) integrate volatility in their valuation model of an operation of an oil well concession. In order to explain the parameters influencing the optimality of the investment decision, they make an analogy with stock options. The evolution of the strategic orientation, considered as a policy of debt reduction or refocusing activity, can also justify the exercise of Abandonment Options. Clark et al. (2010) even inquire as to whether investors value Abandonment Options when they separate from their securities, especially in a context of non-efficient markets (if not, as information is public, valuation cannot be biased). They observe that Abandonment Options are undervalued by about 1% due to early exercise. 2.3.1. Real options within the replacement cycle and disinvestment alternatives Drawing on the Black and Scholes model, Magrabe (1978) suggests an exchange option valuation model in which a company can replace an asset with X 2 as a random price with another asset with X 1 as a random price...
