Question

Within capital budgeting decisions, there are three ‘hidden’ options; option to expand, option to abandon and timing options. Select option to abandon and explain the option in detail with real world example.

Answer 1

Capital Budgeting decisions are made on the basis of its Net present value of the cash flow of the option we are considering. In general , we have three options to make a capital budgeting decision to expand, to abandon and the timing decisions. Please note we can have more options within one category. For example, we can have multple options to expand the project.

Each options have its own pattern of cashflows that can impact the decision making. In an option to abandon the project , we are deciding to sale off the assets and the salvage value received on the assets in present value terms(in cases where liquidation takes lot of time) are compared with the option to expand the project.

To give a real world example, lets say Tata Steel company has a plan to shut down one of its non productive steel factory and liquidate all its assets as the machineries are not producing enough output to cover its expenses. But it also has an option to expand and renovate the factory and increase its output to turn the factory profitable with some probability. Now if it decides to liquidate all the assets and sale the land, it will receive certain amount of cashflows net of all the liquidation charges. Now basis the timing of the cashflows are received we can calculate the net present value of the amount received using the company's cost of capital that is the discount rate. Now we must compare this NPV with the NPV where the company decides to increase the capacity of its machineries and renovate the factory. In expansion, we have an initial outlay and then net cash inflows(or outflows) basis the expectation of the company. Now we calculate the present values of all the expected cashflows and calculate the NPV in the same way. The one with the higher NPV is the feasible solution for the company. Thus abandoning a project can also prove to be a viable option in cases where expansion doesnt generate enough cashflows if proven by lower NPV.

Thank you