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The effects of abandonment options on operating leverage and investment timing

  • Wong, Kit Pong
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    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.

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    Article provided by Elsevier in its journal International Review of Economics & Finance.

    Volume (Year): 18 (2009)
    Issue (Month): 1 (January)
    Pages: 162-171

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    Handle: RePEc:eee:reveco:v:18:y:2009:i:1:p:162-171
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    1. McDonald, Robert L & Siegel, Daniel R, 1985. "Investment and the Valuation of Firms When There Is an Option to Shut Down," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 26(2), pages 331-49, June.
    2. Alexander A. Robichek & James C. Horne, 1967. "Abandonment Value And Capital Budgeting," Journal of Finance, American Finance Association, vol. 22(4), pages 577-589, December.
    3. Sarkar, Sudipto, 2000. "On the investment-uncertainty relationship in a real options model," Journal of Economic Dynamics and Control, Elsevier, vol. 24(2), pages 219-225, February.
    4. Wong, Kit Pong, 2006. "The effects of abandonment options on operating leverage and forward hedging," International Review of Economics & Finance, Elsevier, vol. 15(1), pages 72-86.
    5. Sandmo, Agnar, 1971. "On the Theory of the Competitive Firm under Price Uncertainty," American Economic Review, American Economic Association, vol. 61(1), pages 65-73, March.
    6. Mark Shackleton & Rafal Wojakowski, 2002. "The Expected Return and Exercise Time of Merton-style Real Options," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 29(3&4), pages 541-555.
    7. Brennan, Michael J & Schwartz, Eduardo S, 1985. "Evaluating Natural Resource Investments," The Journal of Business, University of Chicago Press, vol. 58(2), pages 135-57, April.
    8. Alex Triantis & Adam Borison, 2001. "Real Options: State Of The Practice," Journal of Applied Corporate Finance, Morgan Stanley, vol. 14(2), pages 8-24.
    9. Wong, Kit Pong, 2007. "The effect of uncertainty on investment timing in a real options model," Journal of Economic Dynamics and Control, Elsevier, vol. 31(7), pages 2152-2167, July.
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