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.
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.
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.