Real Options The Webber Company is an international conglomerate with a real est
ID: 2799737 • Letter: R
Question
Real Options The Webber Company is an international conglomerate with a real estate division that owns the right to erect an office building on a parcel of land in downtown Sacramento over the next year. This building would cost $55 million to construct. Due to low demand for office space in the downtown area, such a building is worth approximately $53.2 million today. If demand increases, the building would be worth $57.9 million a year from today. If demand decreases, the same office building would be worth only $49.8 million 4. in a year. The company can borrow and lend at the risk-free annual effective rate ofExplanation / Answer
Cost of Construction = 55 Million
Current value of building = 53.2 Million
Based on the demand
If Up, expected value of Building = 57.9 Million
If down, expected value of Building = 49.8 Million
The probability of demand going up or down is assumed to be same viz., 0.50 as there is an equal possibility of one of the events happening
Accordingly
Expected value of building = Value if demand up * probability + value if demand down * probability
= 57.9 Million * 0.50 + 49.8 Million * 0.50
= 28.95 Million + 24.90 Million
= 53.85 Million
Annual Effective rate = 4.8%
Present value of expected value = 53.85 Million * 1/(1+4.8%) = 53.85 Million * 1/1.0480
= 53.85 Million * 0.954198
= 51.3835 Million
Net Present value = Present value of expected value - current estimated value
= 51.3835 Million – 53.2 Million = - 1.8165 Million
Since the net present value is negative, it is profitable to accept the offer of 1.8 Million by local construction company for a right to build the office building.
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.