An empirical investigation into the abandonment option

This study investigates whether Australian equity investors value a firm's ability to abandon its operations either partially or in total, in exchange for the salvage value of its assets. The flexibility that is gained by being able to abandon a firm's operations has value and is known as the abandonment option. This paper tests four propositions relating to the recognition, valuation and behaviour of the abandonment option in the Australian environment. Results show that investors use a function of the firm's asset value to derive the value of the abandonment option. A strong relationship between market value and an accounting measure of the abandonment option is found. Evidence is found to suggest that the salvage value of a firm's assets plays an important role in the valuation of distressed companies. Also a significant industry difference is also found with firms in the resources sector having larger abandonment option values than industrial firms. The findings of this thesis make a strong contribution to the fields of real options and firm valuation. This study provides a base from which future research can develop a practical model of valuing the abandonment option.