Abandonment Option Definition
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. It is valuable the parties where they are obliged to end as a result of the deal not being profitable. In other words, the abandonment option is simply where the management decides whether to continue with the investment project or to end it.
A Little More on What is an Abandonment Option in a Contract
Abandonment is one of the “real options” that is bound to happen depending on the prevailing circumstances. When dealing with various investment projects, it is obvious that a firm will face either one or several options to be able to make changes during a project’s life cycle.
The company may be forced to either expand, wait and invest later or abandon the project altogether. The option a firm takes is highly dependent on various factors surrounding project implementation.
How an Abandonment Option Works
In general, an abandonment option is most common in bilateral agreements where there is no expiry time. In this type of agreement, one party may decide to withdraw from a business deal any time he or she feels like doing so.
There are also no withdrawal penalties if up to date, the value of the completed project happens to be not more than the present value of the projected cash flow of the project’s life cycle. In other words, if what has been spent on the project to date is less than what is supposed to be spent in order to complete the project, then at this point, neither party can face penalties for withdrawing from the project. In this case, early withdrawal before much is spent in a project can be a favorable move that will benefit both parties.
Note that the abandonment option is mostly between two parties (the financial planners and their clients). If after some period of time the returns on investment appear not to be favorable, the contract between the two parties is then terminated. The termination can be initiated by either one of the parties. This is done mostly so as to prevent parties from incurring further acute losses.
Example of Abandonment Option
For instance, let us assume that a contract between an employer and an employee has this specific abandonment option clause included in the contract. In this case, an employee would have not violated any employment provisions should he or she decide to walk away.
On the other hand, an employer would have no right to contest the withdrawal or even press charges against the employee for abandoning or revoking the job agreement. In other words, this abandonment option in a contract provides prosecution immunity to either of the parties during project termination.
Importance of abandonment Option
The abandonment option protects parties’ investment interest in case a project or investment returns are below the parties’ expectations. It is mostly used in bankruptcy filings where assets are given away at a discount. In other words, it gives companies an opportunity to assess the profitability of their project, and also the freedom to withdraw from it, in case, it is not generating the intended profit.
For abandonment option not to attract any penalties, the business contract must be clearly defined. The agreement’s terms must have clear specifications regarding the abandonment option. It must include a clause with specifications that no party will face any penalty in case one of them decides to walk away from the deal.
The Bottom Line
It is true that the abandonment option is an important factor to consider especially where parties foresee a raw deal in a contract. However, it is also important to note that withdrawal from either investment or from a project has serious repercussions to the other party.
Therefore,it is important for parties to weigh the profitability status of an investment or a project early enough. In case there is a foreseen possibility of parties not making profits, early withdrawal, in this case, will be a wise decision for both parties.
They should not wait until they have pumped most of their resources in a project and then one of them decides to withdraw. Early assessment of the investment or project is, therefore, crucial. It will enable parties to know whether or not to continue with the project. This will save them from incurring losses for investing in a project that will later fail to generate good profits for both of them.
Reference for “Abandonment Option”
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 project’s 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 firm’s 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.