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- This topic has 1 reply, 2 voices, and was last updated 3 years ago by John Moffat.
- August 30, 2019 at 1:42 pm #543836ishmero2006Member
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I don’t quite understand the reasoning behind the current price (Pa) of $28m deduced from the scenario given below:
Degrunder,a property development company has gained planning permission for the development of a housing complex at Newtown which will be developed over a three year period.The property sale less building costs have an expected NPV of $4m at a cost of capital of 10% p.a. Degrunder has an option to acquire the land in Newtown at an agreed price of $24m, which must be exercised within the next two years. Immediate building of the housing complex would be risky as the project has a volatility attaching to the NPV of 25%.
One source of risk is the potential for the development of Newton as a regional commercial centre for the large number of professional firms leaving the capital,Bigcity,because of high rent and local business taxes. Within the next two years, an announcement will be made about the development of transport links into Newtown from outlying districts including the area where Degrunder hold the land option concerned. The risk free rate is 5% per annum.
The current price (Pa) of the option to delay the development for two years was found to be $28m,which I don’t really understand.August 30, 2019 at 3:52 pm #543861John MoffatKeymaster
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The cost of the land is $24M and the NPV is $4M.
Therefore the PV of the resulting flows must be $28M and this is the value of the project – i.e. Pa.
I work through an almost identical example in my free lecture on real options.
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