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ACCA Strategic Professional · Advanced Financial Management · Valuation for acquisitions and mergers

In valuing a target, an acquirer includes a separate value for an option to abandon a loss-making division after two years for a known salvage value. Which statement best describes the effect on the valuation?

An abandonment option acts like a put option, with the salvage value as the exercise price. It limits downside losses, so it adds value, and a conventional static NPV that ignores this flexibility understates the true worth of the target's project.

  1. AIt acts like a put option and adds value by limiting downside, so the conventional NPV understates the project's worthCorrect
  2. BIt acts like a call option and reduces the project value
  3. CIt has no effect because the NPV already captures all flexibility
  4. DIt reduces value because abandonment signals failure

Explanation

The right to sell or abandon assets for a fixed salvage amount is a put option on the project's value, with salvage as the exercise price. It truncates losses, so expanded NPV equals static NPV plus the option value. Static NPV ignores this flexibility and therefore understates value.

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