Business
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.
Written by Perlego with AI-assistance
Related key terms
1 of 5
3 Key excerpts on "Abandonment Option"
eBook - ePub- David Heller(Author)
- 2019(Publication Date)
- Wiley-ISTE(Publisher)
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 alternativesDrawing on the Black and Scholes model, Magrabe (1978) suggests an exchange option valuation model in which a company can replace an asset with X2 as a random price with another asset with X1 as a random price. In this context, the value of the investment project w(X1 , X2 , t), which corresponds to the value of a European call option exercisable at the date t
eBook - PDFEntrepreneurial Finance
Venture Capital, Deal Structure & Valuation, Second Edition
- Janet Kiholm Smith, Richard L. Smith(Authors)
- 2019(Publication Date)
- Stanford Business Books(Publisher)
A re-finer who can switch between producing heat-ing oil and gasoline has the real option to switch outputs. Option to abandon An Abandonment Option is a right to discontinue an activity and redeploy the real assets to some other use. Abandonment Options include the options to dis-continue a research project, close a store, or resign from current employment. 182 Chapter Five It follows that the value of a strategy can be dramatically improved by making good choices about what real options to acquire and by using them effectively. The terms of a new-car lease contract, in contrast, do reflect an important financial option premium. When a car is leased, the lessee acquires a financial option. At the end of the lease term, if the market value of the car is high, the lessee can purchase the car by paying a residual value that was negotiated at the time of the original lease transaction. Alternatively, if the market value is low, the lessee can return the car to the lessor so that the lessor bears the downside risk about the future value of the car. Although the underlying asset is real, the car lease contract is a financial option. It is effectively a bet about the future market value of the car, and not an instrument that redeploys the actual (real) use of the asset. 5.8 STRATEGIC PLANNING AND DECISION TREES A decision tree is a useful way to conceptualize strategic alternatives that involve real options. Constructing a decision tree imposes discipline on the evaluation process and helps the entrepreneur identify relevant real options and the points at which critical decisions must be made. It also enables the entrepreneur to assess, in a structured way, the connections between decisions made today and the value of the venture in the future. Building and Pruning Decision Trees A decision tree incorporates both decisions and uncertain events that affect the value of the outcome.
- George H. Pink, Paula H. Song(Authors)
- 2019(Publication Date)
- AUPHA/HAP Book(Publisher)
We can use the data just developed to estimate the value of the Abandonment Option. The NPV with the Abandonment Option is $166,000, while the NPV without this option is −$338,000, so the value of the real option is $166,000 − (−$338,000) = $504,000. However, this value understates the true value of the option because the ability to abandon the project also lowers the riskiness of the project. With lower risk, the difference between the two NPVs is greater than that calculated, although the added value of risk reduction would be relatively small in this illustration as well as difficult to quantify with confidence. Because of this and similar complications, discounted cash flow techniques (when they can be used to value real options) generally will not produce an accurate estimate of the option's value.Here are some additional points to note concerning decision tree analysis and abandonment:- Managers can reduce project risk if they can structure the decision process to include several decision points rather than just one. If MEI were to make a total commitment to the monitoring equipment project at t = 0 and sign contracts that would require completion of the project, it might save some money and accelerate the project, but doing so would substantially increase the project's riskiness.
- Once production or service begins, a business's ability to abandon a project can dramatically reduce the project's risk.
- The cost of abandonment generally is reduced if the firm has alternative uses for the project's assets. If MEI can convert the abandoned monitoring equipment production line to a different, more productive use, the cost of abandonment would be reduced and the monitoring equipment project would become more attractive.
Finally, note that capital budgeting is a dynamic process. Virtually all inputs to a capital budgeting decision change over time, and firms must periodically review both their expenditure plans and their ongoing projects. In the MEI example, conditions might change between decision points 1 and 2; if they do, this new information should be used to revise the probability and cash flow estimates. If a capital budgeting decision can be structured with multiple decision points, including abandonment, and if the firm's managers have the fortitude to admit when a project is not working out as initially planned, risks can be reduced and expected profitability can be increased.
Index pages curate the most relevant extracts from our library of academic textbooks. They’ve been created using an in-house natural language model (NLM), each adding context and meaning to key research topics.
