What is an Abandonment Option
An abandonment option is a clause in a 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 it is unprofitable.
This is a type of "real option," which is an option on a tangible asset, such as a capital improvement project, and not on a financial instrument. In essence, an abandonment option is really the ability of management to decide whether or not to complete that project.
BREAKING DOWN Abandonment Option
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.
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.