Abandonment value is the value of a project or asset if it were immediately liquidated or sold. The abandonment value of an asset or project can vary for many reasons including liquidity, supply-demand factors and implied fair value appraisals performed by certified appraisers.
Abandonment value is also known as liquidation value of an asset. The general rule for deciding to discontinue the product is that if the product’s salvage value is greater than the net present value (NPV) of its expected cash flows, the project is abandoned. It is important for companies to know the profitability of a project and if it is not profitable it is better to discontinue the same. It is an important factor in bankruptcy filings where assets are generally sold at a discount. Theoretically, the optimal economic life of an asset is 4 years, but the project’s expected cash flows may change over the life of the asset. The company should also estimate the future abandonment values in the initial investment phase. It would help the manager to effectively gauge the optimal economic life of an asset.
Why it Matters
A given project's abandonment value can be an important consideration for a company. Should the company learn that not only is a project not profitable but has also incurred costs, it may be more beneficial to liquidate the project for its abandonment value (if the net present value of future cash flows is less)
Valuing an Option to Abandon: An Illustration
Assume that Disney is considering taking a 25-year project which requires an initial investment of $ 250 million in an real estate partnership to develop time share properties with a South Florida real estate developer, and where the present value of expected cash flows is $ 254 million. While the net present value of $ 4 million is small, assume that Disney has the option to abandon this project anytime by selling its share back to the developer in the next 5 years for $ 150 million. A simulation of the cash flows on this time share investment yields a variance in the present value of the cash flows from being in the partnership is 0.09.
The value of the abandonment option can be estimated by determining the characteristics of the put option: Value of the Underlying Asset (S) = PV of Cash Flows from Project = $ 254 million Strike Price (K) = Salvage Value from Abandonment = $ 150 million Variance in Underlying Asset’s Value = 0.09 Time to expiration = Life of the Project =5 years Dividend Yield = 1/Life of the Project = 1/25 = 0.04 (We are assuming that the project’s present value will drop by roughly 1/n each year into the project) Assume that the five-year riskless rate is 7%. The value of the put option can be estimated as follows: Call Value = 254 exp(0.04)(5) (0.9105) -150 (exp(-0.07)(5) (0.7496) = $ 110.12 million Put Value= $ 110.12 - 254 exp(0.04)(5) +150 (exp(-0.07)(5) = $ 7.86 million The value of this abandonment option has to be added on to the net present value of the project of $ 4 million, yielding a total net present value with the abandonment option of $ 11.86 million.