What it means
Traditional project appraisal, such as net present value (NPV), assumes that a company commits to a plan and follows it to the end. In real life, managers can change course.
If sales are weak, they can close a plant, sell the equipment and recover some cash, and an exit option captures the value of that choice. The term comes from real options analysis, which applies the logic of financial options to business decisions.
Just as a put option lets an investor sell at a fixed price, an abandonment option lets a company walk away and receive a salvage value, which is what the assets could be sold for. The worse the outcome, the more valuable the right to leave.
Exit options can take many forms. A project may use leased equipment that can be returned, a contract may include a termination clause, or a firm may hold assets that are easy to resell.
Joint ventures often include buy-sell clauses that let one partner exit at an agreed price. Estimating the value of an exit option requires judgement.
Analysts build scenarios for good and bad outcomes, assign probabilities and compare the result with and without the option to leave. The higher the uncertainty and the higher the salvage value, the more the option is worth.
Managers should also remember the costs and limits. Exiting may involve redundancy payments, penalties and damage to reputation, and some assets, such as specialised machinery, have little resale value.
A clear plan for when to trigger the exit, agreed in advance, helps avoid holding on to a failing project for too long.
In practice
Real-world examples.
Example
A restaurant group opens a new branch in a rented unit with a lease that lets it exit after two years. If trade is poor, it can walk away and move the kitchen equipment to another site. The exit clause lowers the risk of the expansion.
Example
A mining company develops a site with a mobile processing plant that can be moved. If the ore price falls, the company can shut the mine and sell or relocate the plant. The finance team includes the resale value in its project valuation.
Example
A technology firm enters a joint venture with a partner in a new market. The agreement includes a clause that lets either party sell its share to the other at a price based on a formula after three years. This protects the firm if the partnership does not work out.
Formula
Calculation
Value of exit option = Expected value with the option - Expected value without the option
Suppose a company invests in a project that has a 50% chance of a good outcome worth $2,000,000 and a 50% chance of a poor outcome worth $400,000. If things go badly, the company could shut down and sell the assets for $800,000.
Expected value without the option = (50% x $2,000,000) + (50% x $400,000) = $1,000,000 + $200,000 = $1,200,000.
With the option, in the poor case the company takes the higher of $400,000 and $800,000, which is $800,000. Expected value with the option = (50% x $2,000,000) + (50% x $800,000) = $1,000,000 + $400,000 = $1,400,000, so the exit option is worth $1,400,000 - $1,200,000 = $200,000.Case study
Seen in the real world.
Oakridge Fabrication is a fictional manufacturer that considered a $5 million investment in a new line of electric vehicle parts. Demand was uncertain, and the board worried about locking up cash in specialised equipment.
The finance director insisted on choosing machines that could be used for other products and that had a ready second-hand market. She estimated that the equipment could be sold for $2 million if the project failed, and she included that figure in the valuation.
In this illustrative case, demand fell short after two years and the company closed the line. It sold the machines for $1.8 million, slightly below the estimate, but far better than the near zero it might have received for custom-built equipment. The board agreed that the flexibility had been worth paying a little more upfront.
Watch out
Common mistakes.
- Ignoring the exit option, which makes risky projects look worse than they are.
- Overstating the resale value, when specialised assets may sell for much less than expected.
- Forgetting the costs of exiting, such as severance pay and contract penalties.
Questions
People also ask.
Is an exit option the same as an exit strategy?
Not quite. An exit strategy is the plan for leaving an investment, while an exit option is the valued right to leave, treated like a financial option.
How is the value calculated?
Analysts compare the expected outcomes with and without the right to abandon, using scenarios or an option pricing model.
When is the option most valuable?
When the future is highly uncertain and the assets can be sold for a good price, because the right to leave then protects against the worst outcomes.
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