Title: The Effects of Abandonment Options on Operating Leverage and Investment Timing
Reference Number: 1174
Publication Date: July 2007
JEL Classifcation: D21, D81, G31
Author(s):

Kit Pong Wong
The University of Hong Kong

Abstract:

This paper examines how the presence of an abandonment option affects a firm's investment decision in general, and its operating leverage in particular. We show that the value of the abandonment option is a decreasing function of the firm's operating leverage. Upon the introduction of the abandonment option, the firm as such optimally lowers its operating leverage. We further show that there are direct and indirect effects of the abandonment option on the firm's optimal investment trigger, which act against each other. First, the ability to shut down production offers downside protection to the firm, thereby making the firm more eager to exercise the investment option. This is the negative direct effect that pushes down the investment trigger. Second, introducing the abandonment option to the firm induces the firm to lower its operating leverage, thereby making the firm more reluctant to exercise the investment option. This is the positive indirect effect that lifts up the investment trigger. We numerically verify that the overall effect of the abandonment option on the firm's optimal investment trigger is negative.

More:

Published in International Review of Economics and Finance 18 (January 2009), pp. 162-171.

Key words: Abandonment options, Operating leverage, Investment timing

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Last modified: 09/15/2010