FINC2012 Study Guide - Final Guide: Yield Curve, Nominal Interest Rate, Capital Account

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orchidpig108

24 Jul 2018

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Lecture 5: real options: real option valuation is in addition to discounted cash flow (dcf, dcf is static" (does not incorporate the active management of projects, active management: expand/contract, abandon/postpone, switch inputs/outputs. The timing option: consider a now or never" project, can still be thought of as an option, an option at maturity (expiry) If pv > cost or s > x i. e. if npv = pv cost > o: if you can delay your decision 1 year, an option with 1 year to maturity. If the investment cannot be postponed beyond the first year: the pvs are given. C = (cid:4666)q (cid:1829)(cid:3048)(cid:4667) + (cid:4666)(cid:883) - q(cid:4667) (cid:1829)(cid:3031) (cid:1870)(cid:3033) in one years" time? (cid:883). (cid:885)(cid:889)(cid:887) - (cid:882). (cid:890)(cid:890) = (cid:882). (cid:885)(cid:886)(cid:885)(cid:886) Here, the relationship (d = 1/u) does not hold why: it only holds if the underlying return distribution follows the normal distribution assumption. The important assumption was the no arbitrage" requirement that d < rf < u.

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Real options

Nevada Enterprises is considering buying a vacant lot that sells for $1.9 million. If the property is purchased, the company's plan is to spend another $6 million today(t = 0) to build a hotel on the property. The cash flows from the hotel will depend critically on whether the state imposes a tourism tax in this year's legislative session. If the tax is imposed, the hotel is expected to produce cash inflows of $600,000 at the end of each of the next 15 years. If the tax is not imposed, the hotel is expected to produce cash inflows of $1,800,000 at the end of each of the next 15 years. The project has a 14% WACC. Assume at the outset that the company does not have the option to delay the project.

Write out your answers for parts a, b, c and e completely. For example, 13 million should be entered as 13,000,000.

a. What is the project's expected NPV if the tax is imposed? Round your answer to two decimal places. If the answer is negative, use minus sign.
$

b. What is the project's expected NPV if the tax is not imposed? Round your answer to two decimal places. If the answer is negative, use minus sign.
$

c. Given that there is a 50% chance that the tax will be imposed, what is the project's expected NPV if management proceeds with it today? Round your answer to two decimal places. If the answer is negative, use minus sign.
$

d. While the company does not have an option to delay construction, it does have the option to abandon the project 1 year from now if the tax is imposed. If it abandons the project, it would sell the complete property 1 year from now at an expected price of $6 million after taxes. Once the project is abandoned the company would no longer receive any cash flows. Assuming that all cash flows are discounted at 14%, will the existence of this abandonment option affect the company's decision to proceed with the project today?
-Select-yesnoItem 4

Explain.

e. Finally, assume that there is no option to abandon or delay the project, but that the company has an option to purchase an adjacent property in 1 year at a price of $1.5 million (outflow at t = 1). If the tourism tax is imposed, the net present value of developing this property (as of t = 1) will be only $300,000 (so it doesn't make sense to purchase the property for $1.5 million). However, if the tax is not imposed, the expected net present value of the future opportunities from developing the property will be $4 million (as of t = 1). Thus, under this scenario it makes sense to purchase the property for $1.5 million (at t = 1). Assume that these cash flows are discounted at 14%, and the probability that the tax will be imposed is still 50%. What is the most the company would pay today (t = 0) for the $1.5 million purchase option (at t = 1) for the adjacent property? Round your answer to two decimal places.
$

lilacbee181

**SHOW YOUR WORK**

The San Francisco Yacht Company (SFYC), a prominent sailboat builder in San Francisco, is considering developing and marketing a new line of personal sailboards whose design would be based on the âwinged keelâ technology it developed for use in its 12-meter Americas Cup racing yachts. The new sailboard line would be positioned for the upscale personal recreation market.

The project requires an initial investment of $20 million for development and production costs. The success of the project depends highly on whether its sister-product, the 12-meter racing yacht, is successful in its Americas Cup bid. If the racing yacht is successful and wins the Americas Cup (30% probability) then the positive press for the company will boost demand for the sailboard line, and annual cash after-tax cash flows will be $15 million per year for 3 years. If the yacht is successful, but does not win the Americas cup (40% probability) then after-tax cash flows will be $8 million per year for 3 years. If the yacht performs badly (30% probability) then the after-tax cash flows will be only $1 million per year for 3 years. SFYCâs cost of capital is 10%.

a What is the expected NPV of the project?

b Because SFYC owns the winged keel patent, it can wait until after the Americas Cup results are known (one year from now) before undertaking the sailboard project. If it waits, the initial investment will be the same, and SFYC will know which series of cash flows it will receive. The advantage of waiting is that SFYC will know if the bad state of the world, in which the yacht performed badly, has occurred and can choose not to invest if that occurs. Use a decision tree analysis to find the expected net present value of this investment timing decision assuming SFYC delays adopting the project, and only adopts it in the states of the world where the outcome is favorable - that is, it only adopts the project if the NPV of the branch is positive. Assume that the initial investment in Year 1, if the project is undertaken, is known with certainty and is discounted at the risk free rate of 6%, and the project will still last for 3 years (i.e. until Year 4).

c Instead of using a decision tree analysis, use the Black-Scholes Option Pricing Model to analyze this investment timing option. Assume the variance of the projectâs returns is Ï² = 0.45. Hint: One of the inputs to the model is P, the value of the asset underlying the project. Remember that P is the expected present value of the projectâs cash flows when you include both the good cash flows and the bad cash flows, but donât include the initial investment.

orchideel360

You have been asked to evaluate the following two schools of thought in real estate. One school argues that the value of real estate is based on âlocation, location, locationâ; the other school argues that the value of real in todayâs economy must be geared in terms of cash flows. Discuss these two arguments thoroughly!! (Length: no limit

; 15%)

A property produces a PGI of $200,000. Market vacancy rate is estimated at 5%.

The OER is 40% which is also indicative of the market. For this type of property, lenders observe a strict adherence to a coverage ratio (DCR) of 1.20.

Financing is available at 5% with monthly payments for 30 years. The anticipated growth in NOI is 3% per year, compounded: and property value appreciation rate is 4% per year, compounded over 5 year holding period. Assuming a before-tax equity yield requirement of 12%, price (or value) this property on BTCF basis utilizing the Discounted Cash Flow (mortgage equity) framework.(20%)

An investor is considering an investment that has a Market Value of $2.5millions. The following information can be obtained:

Rent = $1,200 per unit per month. Rental Growth Rate = 3% per year compounded.

Number of units = 20

Vacancy rate is 12%.

Operating expenses = $125,000. Operating Expense Growth Rate = 3% per year compounded.

Loan-to-value ratio is 80%.

Interest rate on mortgage is 6%.

Maturity of mortgage = 15 years (with monthly payments).

Financing Costs = $30,000 amortized over life of the mortgage.

Depreciable basis = 75 percent of total cost

Depreciable life = 27.5 years (use 25% max for DEPR tax and 15% for CG tax)

Expected appreciation rate = 3% per year, compounded.

Anticipated Holding period = 5 years

The marginal tax rate of investor is 34%.

Expected Selling Expenses = 6%.

Required after-tax Return on Equity = 8%.

Calculate the NPV and IRR for the project on after-tax basis. (40%)

Calculate the following rules of thumb: Potential Gross Income Multiplier (PGIM); Capitalization Rate(R), Operating Expense Ratio (OER), Equity Dividend Rate (EDR); and Debt Coverage Ratio (DCR); and Brokersâ Rate of

Return for the project. (15%)

Based on the results on (a) and (b), above, will you recommend this project to the equity investor (your client)? Why? How about if your client were to be a mortgage lender, will you still recommend this project to your lender client? Why? (7%)

How are property managers potentially able to enhance value? (3%)

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FINC2012 Study Guide - Final Guide: Yield Curve, Nominal Interest Rate, Capital Account

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