12-1 CONCEPTUAL ANALYSIS OF REAL OPTIONS The destruction that Hurricane Katrina

ID: 2654832 • Letter: 1

Question

12-1 CONCEPTUAL ANALYSIS OF REAL OPTIONS The destruction that Hurricane Katrina brought to the Gulf Coast in 2005 devastated the city of New Orleans as well as the Mississippi Gulf Coast. The burgeoning casino gambling industry along the Mississippi coast was nearly destroyed. CGC Corporation owns one of the oldest casinos in the Biloxi, Mississipi, area, and it was not destroyed by Katrina’s tidal surge because it is located sev-eral blocks off the beach. Because of the near-total destruction of many of the gambling properties located along the beach, CGC is considering the opportunity to make a major renovation in its casino. The renovation would transform the casino from a second-tier op-eration into one of the top attractions along the Mississippi Gulf Coast. The question that the firm faces involves placing a value on the opportunity to renovate the property.CGC’s analysts estimate that it would cost $50 million to do the renovation. However, based on the uncertainties associated with the redevelopment of the region, the firm’s financial analyst estimated that the casino, under the current conditions, would be valued at only $45 million. Alternatively, CGC could continue to operate the casino, in which case it expects to realize an annual rate of return of 10% on the value of the investment. Moreover, the estimated return of 10% is highly uncertain. In fact, the volatility (standard deviation) in this rate of return is probably on the order of 20%, while the risk-free rate of interest is only 5%. a. What is the NPV of renovation of the property if the renovation is undertaken immediately? b. What is the value of having the option to renovate in the future? (Hint: You can as-sume that the option never expires.)

Explanation / Answer

Answer

Answer (a)

CGC’s analysts estimate that it would cost $50 million to do the renovation.

Based on the uncertainties associated with the redevelopment of the region, the firm’s financial analyst estimated that the casino, under the current conditions, would be valued at only $45 million.

Answer : So the NPV of renovation of the property if the renovation is undertaken immediately is -$ 5 million (outflow) [- $50 million (outflow) + $45 million (inflow) ].

Answer (b)

CGC could continue to operate the casino, in which case it expects to realize an annual rate of return of 10% on the value of the investment. The volatility (standard deviation) in this rate of return is probably on the order of 20%, while the risk-free rate of interest is only 5%.

Particulars

Amount

Annual rate of return on the value of the investment

0.1

Volatility (standard deviation) in this rate of return

0.02

(0.2*0.1)

Minimum annual rate of return on the value of the investment (a-b)

0.08

Risk-free rate of interest

0.05

Incremental minimum annual rate of return on the value of the investment (c-d)

0.03

Value of the investment

45000000

The value of having the option to renovate in the future (e*f)

1350000

Answer : The value of having the option to renovate in the future is $ 1,350,000