Investor valuation of the abandonment option: empirical evidence from UK divestitures 1985-1991

This paper looks at divestitures by 144 UK firms listed on the LSE from 1985 to 1991 and investigates whether and how accurately investors price the firm's option to abandon assets in exchange for their exit value. Theory prices this real option as an American style put and the model we test includes the major features of the abandonment option literature: stochastic firm value (the underlying security), stochastic exit value (the strike price), intermediate cash flows and uncertain project life. It also includes random events that can short circuit the optimal timing of the divestiture and trigger abandonment prematurely. The empirical implications are that investors do price the abandonment option but that they price it imperfectly because the exit price is private information. We find that the effects of the timing factor are accurately priced. We also find weak evidence that the probability of forced premature abandonment figures in the option pricing.

Real Options: theory meets practice. 8th Annual International Conference, Montréal, Canada. 17-19 June, 2004.