It has been assumed so far that the firm will operate a project over its full physical life. However, this may not be the best option - it may be better to abandon a project prior to the end of potential life. Any project should be abandoned when the net abandonment value is greater than the present value of all cash flows beyond the abandonment year, discounted to the abandonment decision point. Consider the following example:
Project A has the following cashflows over its useful life of 3 years. The market value (Abandonment value) has also been given.
Year Cash Abandonment
0 (4,800) 4,800
1 2,000 3,000
2 1,875 1,900
3 1,750 0
Determine when to abandon the project assuming a discount rate of 10%.
If the project is used over its life, the NPV is negative as shown below:
NPV = 2,000 x PVIF 10%, 1year + 1,875 X PVIF 10%, 2years + 1,750 X PVIF 10%, 2 yrs - 4,800
= 2,000 x 0.909 + 1,875 x 0.826 + 1,750 x 0.751 - 4,800
= Shs -119
The project should not be accepted. However, if the project is abandoned after 1 year the NPV would be
NPV = 2,000 x 0.909 + 3,000 x 0.909 - 4,800
= Sh -255
If abandoned after 2 years
NPV = 2,000 x 0.909 + 1,875 x 0.826 + 1,900 x 0.826 - 4,800
= Sh 136
The NPV is positive if the project is abandoned after 2 years and therefore this is the optimal decision.
Note that abandonment value should be considered in the capital budgeting process because, as our example illustrates, there are cases in which recognition of abandonment can make an otherwise unacceptable project acceptable. This type of analysis is required to determine projects economic life.