Abandonment Option (Contract) - Definition
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What is an Abandonment Option?
An abandonment option refers to a section in a contract that gives parties in the contract the right to withdraw from a business deal before it matures. In other words, the abandonment option simply grants the ability to the option holder to continue with the investment project or to end it.
The abandonment option protects parties by giving them an opportunity to assess the profitability of their project, agreement, or investment, and also the freedom to withdraw from it, in case, it is not generating the intended profit. Abandonment options may generally be exercised without penalty.
Academic research on Abandonment Option
- Investor valuation of the abandonment option, Berger, P. G., Ofek, E., & Swary, I. (1996). Journal of financial economics, 42(2), 259-287. This article asserts that the authors carries out an investigation in order to assure whether the investors price should be taken as an option when abandoning a firm at its exit value. When .American is combined with both a stochastic strike price also known as the exit value and a stochastic value of the underlying security which is also referred to us as the value of cash flows results to the term known as real option; this term is priced by the theory .Some of the conclusions made are: firm value increases in exit value which results when the expected going -concern cash flows are controlled and the other one is that the more the generalizable assets the more the abandonment option value produced. Finally, the predictions of abandonment option theory is strongly supported by the authors when they used discounted earnings forecasts in that case of expected cash flows and categorizing asset generalizability using the prior literature.
- Profits versus losses: Does reporting an accounting loss act as a heuristic trigger to exercise the abandonment option and divest employees?, Pinnuck, M., & Lillis, A. M. (2007). The Accounting Review, 82(4), 1031-1053. This article looks into a powerful heuristic that is represented by profits and losses which are the two binary classifications of the firms. The impact of these earning heuristic on the firm was examined and the focus was majored on the earnings management actions of the firms making small profits. In this study, the authors assert that firms are triggered heuristically to exercise the abandonment option and to discard the unproductive investments as a result of reporting an accounting loss. The authors finds out that there is an existence of a sharp and economically significant discontinuity around zero in the level of investment in labor between small profits and losses firms This discontinuity is brought about by the loss firms when they are having a lower-than-expected level of investment in labor when their economic fundamentals is provided. Furthermore, the authors also find out that this discontinuity is as a result of exercising the abandonment option. Lastly, the results shows that labor is hindered to a greater extent by firms moving from profit to loss than those firms with the same earnings but with no losses. In conclusion, accounting loss heuristic acts as a major disciplinary that resolves agency problems.
- Valuation characteristics of equity book value and net income: Tests of the abandonment option hypothesis, Barth, M. E., Beaver, W. H., & Landsman, W. R. (1996). Available at SSRN 2762. The tests hypothesis about the impacts of the abandonment option on equity book value and net income valuation characteristic is carried out in this study. As per the predictions, pricing arises and explanatory power of book equity or net income increases or decreases as firms moves towards liquidation or bankruptcy. The pricing also multiples on as explanatory power book of equity or net income are higher or lower In conclusion, net income and equity book value valuation characteristics differs as predicted across the three illustrative industries.
- Uncertainty and the abandonment option, Schnabel, J. A. (1992). Uncertainty and the abandonment option. The Engineering Economist, 37(2), 172-177. In this paper, the option pricing analysis is applies to the .problem of valuing the abandonment option of an investment proposal. There are two assumptions made: the abandonment option is exercisable at only one point in time and that is in future and the other one is the projects vatue-in-use and its lognormally distributed. The model is employed in two instances; when measuring the uniqueness of the project asset and when the value of the abandonment option is affected during the process of measurement. According to the authors, the results shows that the more unique the asset or the higher the correlation, the lower the value of the abandonment option. The other instance where the model is employed is when examining the effect of increased uncertainty in the two variables of the abandonment option value. The relationship between the model and the value of the abandonment option is said to be non-monotonic. However, the value of the abandonment option is enhanced when uncertainty is increased in either one of the two variables
- Investor valuation of the abandonment option: Empirical evidence from UK divestitures 1985-1991, Clark, E., Gadad, M., & Rousseau, P. (2010). Investor valuation of the abandonment option: Empirical evidence from UK divestitures 1985-1991. Multinational Finance Journal, 14(3/4), 291-317. This paper examines the divestitures by 144 firms in UK that are listed on the Landon on Stock Exchange from 1985 to 1991.It also carries out an investigation onto whether and how exactly investors price the firms option to abandon asset in exchange for their exit value. This real option is priced by the theory as an American style put. The models that the authors test include stochastic firm value, stochastic exit value, intermediate cash flows and the uncertain project life. Random events that can short circuit the optimal timing of the divesture and trigger abandonment prematurely is also included in the model. It can be concluded that investors always price the abandonment option although they do it imperfectly. This is because the exit price is private information. It is evidenced that the effects of the timing factor are accurately priced and that there is probability of forced premature abandonment figures in the option pricing.