Strategic Parameters for Capital Budgeting When Abandonment Value is Stochastic

In this paper we look at capital budgeting techniques when the abandonment value is stochastic. We investigate how these techniques can be exploited as management tools to aid not only in the invest/abandon decision but also in ongoing project management, financial forecasting and the timing of strategic moves. We develop a model with stochastic abandonment value that highlights three parameters - the expected growth rate of the salvage value, the volatility of percentage changes in the salvage value and its correlation with the rate of return on the investment itself. Two of these parameters, volatility and correlation, interact with the volatility of the return on the investment in surprising ways, with increases at first decreasing the option value up to a critical point and increasing it thereafter. This insight affects the decision making process, depending on what side of the critical point the firm finds itself. Finally, we use examples and simulations to show how the model can be applied in practice as an important input in the decision to invest or divest. We also show how the model can be used as a management tool for financial planning, monitoring ongoing investments, and for the timing of strategic moves