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    Abandonment Option

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    Angelica Allanic
    Real options provide managers flexibility to alter cash flows from real assets that are not passive investments like stocks. There are several types of real options including growth, abandonment, timing, and flexibility options. An abandonment option allows a project to be shut down if cash flows are low, which lowers risk and increases expected profits. For an example project Y, the NPV is negative without considering the value of the abandonment option, but that option reduces risk and should lower the discount rate used in the NPV calculation.

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    Abandonment Option

    Uploaded by

    Angelica Allanic
    58 views3 pages
    Real options provide managers flexibility to alter cash flows from real assets that are not passive investments like stocks. There are several types of real options including growth, abandonment, timing, and flexibility options. An abandonment option allows a project to be shut down if cash flows are low, which lowers risk and increases expected profits. For an example project Y, the NPV is negative without considering the value of the abandonment option, but that option reduces risk and should lower the discount rate used in the NPV calculation.

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    Real options provide managers flexibility to alter cash flows from real assets that are not passive investments like stocks. There are several types of real options including growth, abandonment, timing, and flexibility options. An abandonment option allows a project to be shut down if cash flows are low, which lowers risk and increases expected profits. For an example project Y, the NPV is negative without considering the value of the abandonment option, but that option reduces risk and should lower the discount rate used in the NPV calculation.

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    58 views3 pages

    Abandonment Option

    Uploaded by

    Angelica Allanic
    Real options provide managers flexibility to alter cash flows from real assets that are not passive investments like stocks. There are several types of real options including growth, abandonment, timing, and flexibility options. An abandonment option allows a project to be shut down if cash flows are low, which lowers risk and increases expected profits. For an example project Y, the NPV is negative without considering the value of the abandonment option, but that option reduces risk and should lower the discount rate used in the NPV calculation.

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    © All Rights Reserved
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    Download as docx, pdf, or txt
    of 3

    Group 4

    Real Options and Other Topics in Capital Budgeting

    Introduction to Real Options

     DCF techniques were originally developed to value securities such as stocks and
    bonds. Those securities are passive investments—once they have been
    purchased, most investors have no influence over the cash flows they produce.3
    However, real assets are not passive investments—managers can often take
    actions to alter the cash flow stream. Such opportunities are called real options—
    “real” to distinguish them from financial options like an option to buy shares of GE
    stock, and options because they provide the right but not the obligation to take
    some future action that can increase cash flows.
     Real options are valuable, and as this value is not captured by conventional NPV
    analysis, it must be considered separately.

    Several Types of Real Options

     Growth/expansion options
     where the project can be expanded if demand turns out to be stronger
    than expected
     Abandonment/shutdown options
     where the project can be shut down if its cash flows are low
     Investment timing options
     where a project can be delayed until more information about demand
    and/or costs can be obtained
     Flexibility options
     where the input/output used can be changed if availability or market
    conditions change
    Abandonment/Shutdown Option

     where the project can be shut down if its cash flows are low
     If the firm has the option to abandon a project during its operating life, this can
    lower its risk and increase its expected profitability.

    Illustration:

     Project Y has an initial, up-front cost of $200,000, at t = 0. The project is


    expected to produce after-tax net cash flows of $80,000 for the next three years.
     At a 10% WACC, what is Project Y’s NPV?

    Year Flow Present value Computation

    0 $(200,000) $(200,000)

    1 80,000 72,727.27 80,000/(1.10)^1

    2 80,000 66,115.70 80,000/(1.10)^2

    3 80,000 60,105.18 80,000/(1.10)^3

    NPV =$(200,000) + 72,727.27 + 66,115.70 + 60,105.18= $(1,051.85)


    Should the abandonment affect the project’s WACC?
     Yes, the abandonment option should have an effect on the WACC.
     The abandonment option reduces risk, and therefore reduces the WACC.

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