Review of Accounting Studies, 8, 29–45, 2003
2003 Kluwer Academic Publishers. Manufactured in The Netherlands.
Abandonment Options and Information
The Ohio State University, 2100 Neil Avenue, Fisher College of Business, Columbus, Ohio 43210-1399
Carnegie Mellon University, Graduate School of Industrial Administration, Pittsburgh, Pennsylvania 15213-3890
Abstract. We study a principal-agent model of moral hazard in which the principal has an abandonment option.
The option to abandon a project midstream limits a ﬁrm’s downside risk. From a consumption (production)
perspective, the option is clearly beneﬁcial. However, from an incentive perspective, the option can be costly.
Removing the lower tail of the project’s underlying cash ﬂow distribution also eliminates the information it
contains about an agent’s (unobservable) productive input. In addition, there is also the issue that the option
holder cannot always (ex ante) commit to the precise circumstances under which the option will be exercised.
These concerns introduce an interaction in the valuation of the abandonment option and information system. In
particular, the manner in which information is coarsened and the direction of the ﬂow of information are critical
design parameters that affect option value.
Keywords: real options, incentives, information system design
JEL Classiﬁcation: D21, D82, G13, G31
The real option framework expands the passive net present value (NPV) analysis to include
the value added by ﬂexible decisions made by active management. These decisions may
include deferring investment because of uncertainty in output or input prices, abandoning
a project if resale values of capital equipment in the second-hand market are particularly
appealing, accelerating resource utilization if market conditions are more favorable than
expected, or investing early in R&D if competitors are threatening. When the role of active
management is recognized, it can lead to investment decisions which appear counterintuitive
to those grounded in traditional discounted cash ﬂow techniques. That is, it can sometimes
be optimal to reject a positive NPV project (Titman, 1985) or to accept a negative NPV
project (Lambrecht, 2000).
For the most part, real options have been valued in single-person decision problems. In
these settings, operating cash ﬂows are consumed by the decision maker. The value of the
real option depends on the extent to which its availability enhances the decision maker’s
consumption. In contrast, in agency (moral hazard) models, cash ﬂows serve both a
consumption and an informational role. In addition to consuming cash ﬂows, the principal