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The effects of abandonment options on operating leverage and investment timing

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  • Wong, Kit Pong

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.

Suggested Citation

  • Wong, Kit Pong, 2009. "The effects of abandonment options on operating leverage and investment timing," International Review of Economics & Finance, Elsevier, vol. 18(1), pages 162-171, January.
  • Handle: RePEc:eee:reveco:v:18:y:2009:i:1:p:162-171
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    References listed on IDEAS

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    7. 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.
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    9. 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 331-349, June.
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    Citations

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    Cited by:

    1. Wong, Kit Pong & Yi, Long, 2013. "Irreversibility, mean reversion, and investment timing," Economic Modelling, Elsevier, vol. 30(C), pages 770-775.
    2. Sarkar, Sudipto & Zhang, Chuanqian, 2015. "Underinvestment and the design of performance-sensitive debt," International Review of Economics & Finance, Elsevier, vol. 37(C), pages 240-253.
    3. Chow, Clement K.W. & Song, Frank M. & Wong, Kit Pong, 2010. "Investment and the soft budget constraint in China," International Review of Economics & Finance, Elsevier, vol. 19(2), pages 219-227, April.
    4. Jou, Jyh-Bang & Lee, Tan (Charlene), 2016. "How does statutory redemption affect a buyer's decision at the foreclosure sale?," International Review of Economics & Finance, Elsevier, vol. 45(C), pages 263-272.
    5. Kamoto, Shinsuke, 2015. "Strategic capacity expansion under a potential entry threat," International Review of Economics & Finance, Elsevier, vol. 38(C), pages 157-177.
    6. Lu, Jin-Ray & Hwang, Chih-Chiang & Lin, Chien-Yi, 2016. "Do shareholders appreciate capital investment policies of corporations?," International Review of Economics & Finance, Elsevier, vol. 43(C), pages 344-353.
    7. Kim, Hwa-Sung, 2016. "Performance-based bonuses for investment and abandonment decisions," Finance Research Letters, Elsevier, vol. 18(C), pages 120-126.
    8. Wong, Kit Pong, 2010. "The effects of irreversibility on the timing and intensity of lumpy investment," Economic Modelling, Elsevier, vol. 27(1), pages 97-102, January.
    9. Liu, Yu-hong & Jiang, I-ming, 2012. "Influence of investor subjective judgments in investment decision-making," International Review of Economics & Finance, Elsevier, vol. 24(C), pages 129-142.
    10. Lukas, Elmar, 2013. "Modeling the transitional dynamics of international joint venture policies: An option pricing approach," International Review of Economics & Finance, Elsevier, vol. 27(C), pages 21-36.

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