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- Find the value of the real option for both market conditions and state if the project should be accepted.
Find the value of the real option for both market conditions and state if the project should be accepted.
Question Description
Knights Development is considering buying a vacant lot that is selling for $1.5 million. It will take them two years to permit and construct a large retail center and will cost an additional $1 million in permitting and $2.5 million in construction. Permitting will occur in year 1 at which time if the market has shifted, they can abandon the project without incurring the cost to construct but also not gaining any future cash flows. If they do abandon the project, they anticipate being able to sell the land with permits for $4.5 million at the end of year 1. Construction will occur in year 2. If there is a shift in the market for retail space between purchase and start of operations (but after permitting) the after-tax cash flows would be $1,980,000 rather than the strong market of $3,300,000 for the next 10 years. They anticipate being able to sell the property at the end of the 10-year hold for an after-tax value of $60,000,000 if the market is good and $26,400,000 if the market is bad. There is 50% chance of a change in market (at any decision point, aka after permitting, at expansion option and at sale). Finally, assume if there is no option to abandon or delay the project, but that the company has the option to expand the facility at a cost of $2 million in year 3. If the market is good the net present value of developing this additional property (as of t=3) is $4 million, but if the market is bad then the net present value of development would be $1 million (so it wouldn’t make sense to expand). Knight’s Development has a discount rate of 12%.
- Find the value of the real option for both market conditions and state if the project should be accepted.
- Find the value of the abandonment option under both market conditions and if they should choose to abandon the project rather than proceed with construction. (Assume you will only abandon is the market has already shifted at end of permitting).
- Find the value of the expansion option and the state if the expansion should occur.
- Prepare all your work in Excel and upload a completed Excel File with answers to the objectives typed in.
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