Abandonment Options and the Financial Boundaries of the Firm

Abstract

Two business units are said to have a financial boundary between them if their shares are separately traded. When business units are financially integrated, the risks associated with transactions among them will not affect the stock price of the integrated firm. This risk reduction can provide better insurance for risk-averse managers and improve managerial incentives. On the other hand, financial integration permits managers to free-ride each others. It also reduces the value of the abandonment option, making businesses less responsive to changes. Due to the abandonment option, information conveyed by the stock price of the integrated firm cannot be duplicated by those under nonintegration. The conditions under which integration or nonintegration is optimal are derived in terms of the invested capital, the volatility of the intermediate good/service market, the abandonment (liquidation) value, and the importance of managerial input. It is shown that vertical integration is more likely to occur than conglomerate mergers because vertical integration results in more risk reduction. Numerical examples are provided.

JEL Classification: D23, G34, L22