Calculating abandonment value using option pricing theory

Conventional capital budgeting procedure values investment projects as if they will be undertaken for a given economic life, and assigns a prespecified salvage value to the assets at the end of the life. This ignores the value of the option to abandon the project early. This paper models the abandonment option as an American put option on a dividend paying stock, with varying dividend yield and exercise price. A general procedure for calculating the abandonment value is presented, along with some numerical examples illustrating its practical importance.

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