Tuesday, December 14, 2010


Abandonment Option in Investment Evaluation

Most investments relating to expansions or diversification's require large amount of funds. Once the decision has been made and funds have been committed, these decisions cannot be reserved without incurring huge losses. When uneconomical investment projects are sold or discarded, it is quite difficult to get a good value. In case of some projects the firm may have to incur substantial dismantling cost. In such projects, which may turn out to be quite unprofitable under adverse economic conditions, the firm may like to have the option to abandon gives flexibility to the firm to exit without much loss.


Chemical company is considering building a new plant to diversify into the production of urea. The company has two proposals with regard to technology. Proposal A is to build a custom designed, integrated plant using the latest technology that produces urea and by-products in the most economical way. A less expensive and less profitable scheme, proposal B, is to build a standard plant for manufacturing urea. If economic conditions turn out to be unprofitable, and the firm wants to exit from the urea business, it will be difficult for the firm to sell the plant built under proposal A, but it may be able to sell the plant built under proposal B because of its low investment cost. The government policy has a major impact on the company’s decision. If the current government policy of imports restrictions and fixing the price of urea equal to the cost plus 12% profit on net worth at 85% capacity continuous, proposal A is the better choice. On the contrary, if the current policy changes and the government allow imports and market-determined urea prices, the company may prefer proposal B now so that it has an option to abandon the project by selling it to a larger player in the urea market. Proposal B has, in effect, a put option attached to it, giving the flexibility to abandon the proposed operation in favor of some other activity.

Valuing the option to abandon

How do we value the option to abandon? Suppose the present value of proposal B is 100 million $ without the abandonment option. If the market conditions turnout to be favorable and demand for urea is high, the value of the project at year one increases by 30% to 130 million $. On the contrary, if the market conditions are unfavorable and demand is low, the projects value declines by 40% to 60 million $. Suppose if chemical company does not want to continue with the project, it can sell it for 80 million $. You can recognize that id demand for urea is law at year 1, and then the project value is 60 million $, and it is beneficial for chemical company to abandon the project and realize 80 million $. The value of option when the company exercises it will be 20 million $. (80 million – 60 million). However, chemical company will continue with the project if demand is high, as the company will loss value by exercising the option.

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