Investor Valuation of the Abandonment Option

Abstract

We investigate whether investors price the option to abandon the firm for its liquidation value. Theory prices this real 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 liquidation value, after controlling for expected going-concern cash flows, and that more generalizable assets produce more abandonment option value. Using discounted earnings forecasts to proxy for expected cash flows, and relying on prior literature to categorize asset generalizability, we find strong support for abandonment option theory s predictions.