Investor Valuation of the Abandonment Option

Abstract

We investigate whether investors use balance sheet information to value their option to abandon the continuing business in exchange for the assets' exit value. As opposed to papers that examine the potential for balance sheet disclosures to provide incremental information about the expected level of future going-concern cash flows, our study assesses the extent to which balance sheet information affects firm value given the level of expected going-concern cash flows. Theory prices the abandonment option as an American put with both a stochastic strike price (liquidation value) and a stochastic value of the underlying security (the value of cash flows). The major empirical implications are that firm value increases in exit value, after controlling for expected going-concern cash flows, and that more generalizable assets produce more abandonment option value. Using discounted analysts' earnings forecasts as an input in the construction of a proxy for expected cash flows, and relying on prior literature to categorize asset generalizability, we find strong support for abandonment option theory's predictions.

JEL Classification: G13, G33, G35, M41