Abandonment Option

If market conditions deteriorate severely, management can abandon operations and realize resale value of project assets in second-hand markets. Abandonment options are important in capital-intensive industries, financial services, and new product introduction in uncertain markets.

In a competitive industry with over capacity management has to continuously consider whether to stay or get out. The actual decision depends on the value of the project below which management may choose to abandon and the value above which extension could take place. An abandonment option is a put option.

The development of an oil field consists of sequential investments in test drilling, evaluation drilling, and production capacity. The investment in test drilling is a first step in a series of investments. The company has the option to abandon the project at various stages depending on the payoffs. Likewise, pharmaceutical companies hold valuable abandonment options.

Glaxo is a pharmaceutical firm that aims to be the worldwide leader in the research, development, and marketing of drugs for human consumption. Since 1980, Glaxo concentrated its activities on prescription drugs, focusing its skills and resources on the development of safer and more effective drugs. An area of focus where Glaxo can have competitive advantage is antibiotics.

Shortly after starting antibiotics in therapy, bacteria mutate faster producing enzymes that inactivate the drug reducing its therapeutic value ("b-lactamase" process). Glaxo's research laboratories isolated a new synthetic compound (Trib-actam) to prevent this effect. The development enhances Glaxo's strategy to be a leader in antibiotics. A drug development project goes through the following milestones:

Activity Year

Primary research 0

Patent filing 2

Pre-clinical tests 3

First stage trials 4

Patent group 6

Second stage trials 8

Third stage trials 11

Regulatory approval 12

Launchoral 13

Glaxo can either launch both oral (solid) injectable versions at the same time or launch the injectable version a year later. The second strategy has less risk since oral version has wider market use and the entry into the hospital market would be more informed. The main driver in this case is the demand uncertainty of oral version. Glaxo, in essence, owns an abandonment option at the third stage and a growth option into hospital market within a year following the successful launch of oral version.

The project can be abandoned during development if PV from continuing is less than planned (third stage) investment or if salvage value (e.g., from selling rights to biotech firm) is higher.

The option to abandon planned third stage development (or sell for salvage value) depends on follow-on option to expand (injectable). There are states where project has negative NPV but is worth investing to capture value of option to expand later. Exercising abandonment kills option to expand later. The forecast of free cash flows is shown in Exhibit 12.6.

The volatility of demand was estimated to be 35%. Given a risk-free rate of 3% and a salvage value of 5million the real option value works out to £29.3 million (the option to expand has a value of 14.6 million and the option to abandon has a value of 14.7 million). So, the true value of the project is —2.7 million +29.3 million = 26.6 million, not —2.7 million as the DCF methodology suggests.

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