What is an Abandonment Option?

An abandonment option is a clause in an investment contract granting parties the right to withdraw from the contract before maturity. It adds value by giving the parties the ability to end the obligation if conditions change that would make the investment unprofitable.

Key Takeaways

  • Abandonment options apply to investment contracts on tangible assets.
  • This option gives the investor less risk by being able to withdraw commitment under certain conditions.
  • This option is one of four real option types that can appear in investment contracts.

How an Abandonment Option Works

An abandonment option is really the ability of management to decide whether or not to complete that project. An abandonment option is one of four types of real option (options on tangible assets) that can be added to investing projects such as gold mines, airline planes, cargo ships, heavy equipment, and so forth.

Abandonment options are commonly used in bilateral agreements without a set time frame for expiry. Usually, one party may decide to exit from the relationship without penalty if the salvage value of the project completed to date exceeds the present value of the project's expected cash flows over the life of the project's contract.

The business contract must explicitly state the option as part of a contract's terms and specifies that neither party will incur any penalties should either of them invoke the abandonment clause. A good example would be if an employee withdraws from an employment contract containing an abandonment option. In this case, employer cannot contest this withdrawal.

An abandonment option often appears in contracts between financial planners and their clients. Should the return on investments managed by the planner be below expectations after a certain period of time, any contract between the planner and the client may be terminated.

Another place where an abandonment option may appear is within a lease contract of one kind or another. Real estate rental leases in high demand areas would not likely offer such clauses, but if circumstances were such that the landlord was having trouble attracting tenants in a high-rent commercial property, for example, they might add an abandonment clause rather than lower rents.

Real Options

A real option is a choice made available to the managers of a company with respect to business investment opportunities. It is referred to as “real” because it typically references projects involving a tangible asset instead of financial instrument

In an industrial setting, a business partner promises a certain range of return on investment. If, after one year, for example, the returns on that investment are below expectations. The client will determine if the salvage value of the project, gained thought the sale of the project or its liquidated parts, is greater than the expectations for the following years of the life of the project. If the salvage value is greater than the net present value of those cash flows, the client will likely abandon the project.

Likewise, if the business partner finds that their expenses are greater than the its share of the cash flows, the partner may also terminate the project so as not to lose any more money.

Abandonment options, as well as other real options, are attractive features because they protect both party's interests in case the contract fails to generate the desired benefit. While not a legality, each party must understand that withdrawal could negatively impact the other party.