How do I value the abandonment option on a failing project?

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AcadiFi · Accepted Answer

An abandonment option is a put on the project: management can 'sell' continuing operations and receive the salvage value V_s at any time before project end...

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For Copperstead: current PV of continuing operations S = $58M, salvage value K = $45M today (declining at 6% per year), remaining life T = 5 years, operating-cash-flow volatility 40%, risk-free 4%. Treat as an American put with declining strike. A binomial tree with 60 steps gives an option value around $11M.

Without the abandonment option, the DCF of continued operations alone is $58M. Adding the put raises project value to about $69M. That $11M premium represents the downside protection offered by the ability to shut down if copper prices collapse.

Why this matters for real capital allocation: embedding an explicit abandonment right (via contract design, asset structure, or joint venture exit clauses) genuinely increases intrinsic project value. Many CFOs under-weight this because abandonment 'feels like failure'. It is not — it is rational option exercise.

AcadiFi CFA candidates: exam vignettes often describe 'salvage value at year N' as if it's only available at the end. Read carefully. If salvage is available throughout, it's an American option, which is more valuable than a European one. Binomial trees handle both easily; closed-form Black-Scholes applies only to European-style options.

How do I value the abandonment option on a failing project?

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