ABANDONMENT VALUE

Definition: Abandonment value is the equivalent cash value of a project if it is liquidated immediately after reducing all debts which need to be repaid.

Description: Abandonment value is also known as liquidation value of an asset. The general rule for deciding to discontinue the product is that if the product’s salvage value is greater than the net present value (NPV) of its expected cash flows, the project is abandoned.

It is important for companies to know the profitability of a project and if it is not profitable it is better to discontinue the same. It is an important factor in bankruptcy filings where assets are generally sold at a discount.

Theoretically, the optimal economic life of an asset is 4 years, but the project’s expected cash flows may change over the life of the asset. The company should also estimate the future abandonment values in the initial investment phase. It would help the manager to effectively gauge the optimal economic life of an asset.

For example:

A company’s cost of capital is 10%, and the initial investment cost to be incurred at the beginning of the project is Rs 3,50,000. Future cash flows expected in the next 4 years are 2,00,000, 1,50,000, 10,0000 and 50,000.

Now, if we calculate the net present value of each of the cash flows and subtract it with the initial investment value, it still comes out positive, which is Rs 65,067.

Considering the fact that NPV is still greater than zero, the company should continue with the project and not exercise the option.


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