PART 3: CAPITAL BUDGETING
In legal systems, such as those in Australia and New Zealand, that provide limited liability to
corporations, shareholders have the ultimate abandonment option. A company may borrow money to
finance its operations, but if it cannot generate cash flow sufficient to pay back its debts, then management
may declare bankruptcy, turn over the company’s assets to its lenders and let the shareholders walk away.
Although declaring bankruptcy is not what shareholders hope for when they invest, it means that the
most shareholders can lose is their initial investment. Put another way, investors who buy shares are
willing to pay a little more because of the embedded option to abandon (in this case, the default option)
than they would be willing to pay without that option. We can express this mathematically as follows:Share value = NPV + Value of default option
Consider the same situation from the lender’s perspective. When lenders commit funds to a
corporation, they know that the borrower may default and that the lender’s ability to recover the associated
losses does not extend to the shareholders’ personal assets. We could even say that an investor who buys
a bond from a corporation is simultaneously selling an option to the company – the option to default. So
the price paid by the investor for the bond is effectively net of the proceeds from the option to default.
Typically, we assume that an option to default is essentially absent in government securities, although
some countries have, over time, defaulted or partially defaulted on their debt: most recent concerns
with such European economies as Greece, Spain and Italy have focused on the ability of their national
governments to fully repay their debts; and Greece has already been given the option of providing only
partial repayment of some of its debt. But if a government bond and a corporate bond offer the same
interest payments to investors, which one would sell at a higher price? The government bond, because:Corporate bond value = Government bond value – Value of company’s default option
Abandonment options crop up in unexpected places, and it is important for managers to recognise
whether a given investment has an attached abandonment option or grants another party the right to
abandon. Consider refundable and non-refundable airline tickets. With a refundable ticket, the traveller
has the right to abandon travel plans without incurring a penalty. Such a ticket is more valuable than one
that requires a traveller to pay a penalty if plans change.Flexibility Options
Other options that have recently come to prominence in capital budgeting analyses are collectively known
as flexibility options. Three examples illustrate the nature of flexibility options. First, the ability to use
multiple production inputs creates option value. An example of such input flexibility is a boiler that can
switch between oil or gas as a fuel source, enabling managers to switch from one type of fuel to another
as prices change. Second, having a flexible production technology capable of producing (and switching
between) a variety of outputs using the same basic plant and equipment can be useful. For example, an
oil refiner can switch its output between different grades or types of fuel, such as 87 or 91 octane gas or
kerosene. This type of output/operating flexibility creates value when output prices are volatile.
Finally, option value can be created by maintaining excess production capacity that can quickly
be used to meet peak demand. Although it is costly to purchase and maintain, this capacity flexibility
can be quite valuable in capital-intensive industries subject to wide swings in demand and long lead
times for building new capacity. For example, consider the profit opportunities a multinational company
can employ if it has the excess capacity needed to move production around the world in response to
movements in the real exchange rate. In 2010 and 2011, this capacity flexibility was demonstrated in
Australia in the completion of desalination plants in New South Wales and Victoria in order to provide
additional drinking water for residents of those states if water levels in the main freshwater reservoirs