Question

1. You are looking into the purchase of a condominium complex for your privately-held real estate firm REInvest Corp. The condominium complex would cost $38 million today. This condominium complex would be a typical investment for CondoPlus Inc. You think that the outcomes of this investment will depend on how the economy does in the near future. You think that there is a 40% chance that the economy will keep improving. This will result in CFs of $5 million next year, with the CFs increasing by 5% per year into perpetuity. There is a 30% chance of the economy growing very slowly, which will result in CFs of $3 million next year with 2% growth per year in perpetuity. And there is a 30% chance that the economy will shrink, causing CFs to be $1 million next year with only 1% growth per year into perpetuity. You could purchase an option to sell the condominium complex exactly 1 year from now for $25 million. How much is this option worth? The discount rate is 12%.

Answer 1

Answer is given herein below.

Since there are multiple scenarios of cash flows and option worth is given for all the three scenarios.

				USD Millions
Sl No	Different Scenario of Growth	40%	30%	30%
1	Cash Flow in Next one Year	$           5	$           3	$                 1
2	Present Value of CF in next One year	$     4.46	$     2.68	$           0.89
3	Option to Sale in Next one year	$         25	$         25	$              25
4	Present Value above	$   22.32	$   22.32	$         22.32
5	Total Present Value (2+4) Options Worth	$   26.79	$   25.00	$         23.21
	Discount rate 12%
	(Formula for Present Value is (Amount of Cash Flow/(1+Discount Rate)^n
	(Where n is number of years)