The management at Sevenglobe Motors considered the option to abandon when building their new manufacturing plant. The design of the plant allows it to easily be converted to manufacture other types of large machinery. If their new line of cars is poorly received, their plant should be easy to sell to another manufacturing company. In this example, the extra cost of building the plant in such a way that it can easily be converted for other uses resembles:

Question

Quizplus · Accepted Answer

The extra cost of building the plant in such a way that it can easily be converted for other uses is similar to the premium paid for a put option, which gives the holder the right to sell an underlying asset at a specified price (strike price). The option premium is the cost of buying the option, which provides insurance against a potential decline in the asset's value. In this case, building the plant in such a way is a form of insurance against a potential failure of the new car line, and the ability to sell the plant to another manufacturer is similar to exercising the put option.

The Management at Sevenglobe Motors Considered the Option to Abandon