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Strategic parameters for capital budgeting when abandonment value is stochastic

Author

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  • Ephraim Clark
  • Patrick Rousseau
Abstract
This paper investigates how capital budgeting techniques that include the option to abandon can be exploited as management tools to aid not only in the invest/abandon decision but also in ongoing project management, financial forecasting and the timing of strategic moves. Three parameters are highlighted — the expected growth rate of the salvage value, the volatility of percentage changes in the salvage value and its correlation with the rate of return on the investment itself. Two of these parameters, volatility and correlation, interact with the volatility of the return on the investment in surprising ways, with increases at first decreasing the option value up to a critical point and increasing it thereafter. This insight has implications for the decision making process. Finally, it is shown how the model can be applied in practice to the capital budgeting process, including investment and disinvestment. It is also shown as to how the model can be used as a management tool for financial planning, monitoring ongoing investments, and for the timing of strategic moves.

Suggested Citation

  • Ephraim Clark & Patrick Rousseau, 2002. "Strategic parameters for capital budgeting when abandonment value is stochastic," Applied Financial Economics, Taylor & Francis Journals, vol. 12(2), pages 123-130.
    • Handle: RePEc:taf:apfiec:v:12:y:2002:i:2:p:123-130
    DOI: 10.1080/09603100110088049
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    References listed on IDEAS

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    1. McDonald, Robert L & Siegel, Daniel R, 1985. "Investment and the Valuation of Firms When There Is an Option to Shut Down," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 26(2), pages 331-349, June.
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    4. Berger, Philip G. & Ofek, Eli & Swary, Itzhak, 1996. "Investor valuation of the abandonment option," Journal of Financial Economics, Elsevier, vol. 42(2), pages 257-287, October.
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    6. Margrabe, William, 1978. "The Value of an Option to Exchange One Asset for Another," Journal of Finance, American Finance Association, vol. 33(1), pages 177-186, March.
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    8. Stulz, ReneM., 1982. "Options on the minimum or the maximum of two risky assets : Analysis and applications," Journal of Financial Economics, Elsevier, vol. 10(2), pages 161-185, July.
    9. James L. Paddock & Daniel R. Siegel & James L. Smith, 1988. "Option Valuation of Claims on Real Assets: The Case of Offshore Petroleum Leases," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 103(3), pages 479-508.
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    Cited by:

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    2. Hubert de la Bruslerie & Catherine Deffains‐Crapsky, 2005. "Takeover bids, unconditional offer price and investor protection," Review of Financial Economics, John Wiley & Sons, vol. 14(2), pages 103-126.

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