The option to divest has quantifiable value, according to Alexander Triantis, Dean, John Hopkins Carey Business School, who developed the following case with the late Dr. Ken Smith, Managing Partner, Dundee Associates, Limited, Toronto, Canada.

Consider the case of PJP,* a large conglomerate contemplating the acquisition of another firm with substantial real estate holdings. If the acquisition goes through, PJP plans to develop a particular piece of centrally located real estate for a distribution facility in two years. Based on its projected use, PJP has valued this piece at $20 million. Market conditions will of course cause the value of this real estate to fluctuate over the next two years. However, if the firm’s business outlook turns sour and the distribution facility is projected to be unprofitable, the firm would be able to sell off this land quickly for at least $15 million.

To account for the value of this divestiture option in its valuation of the acquisition, PJP’s management uses a simple two-year binomial model. Management assumes that the value of the real estate to the firm (without taking into account the divestiture option) will either appreciate by 50 percent or depreciate by 40 percent each year. In the worst-case scenario, the land would be worth only $7.2 million to the company after two years. In effect, the divestiture option established a $15 million floor for the value of the real estate after two years, thus mitigating the risk of the acquisition.

Even though the value to PJP of the real estate as a site for its distribution facility may be only $12 million at the end of the first year, it is still not optimal for the firm to sell it at that time for $15 million if it can sell it for that price at the end of the second year. The firm would prefer to retain the option to develop the land at the end of the second year should business conditions improve (at which point the value of the land as a distribution site would rise to $18 million).

The incremental value of waiting to divest amounts to $710,000 at the end of the first year. Overall, the divestiture option increases the current value of the land from $20 million to $21.77 million. In practice, of course, the resale price of an asset is not guaranteed, and more sophisticated option-pricing techniques would be required. The logic behind the valuation and exercise of a divestiture option, however, is still instructive.

* PJP is a fictional composite based on real cases.