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. USE Decision Tree, then calcolate NPV 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

Using Decision tree;
A) 40 % chance and 5% growth

NPV= 5/(1.12) + 5(1.05)/(.12-.05)"2
= 4.464 + 1071 .42
=1075.9

B) 30 % chance and 2% growth

NPV= 3/(1.12) + 3(1.02)/(.12-.02)"2
= 2.678 + 306
=308.678

C) 30 % chance and 1% growth

NPV= 1/(1.12) +1(1.01)/(.12-.01)"2
=0.892 + 83.471
=84.363

So Total NPV =
0.4* 1075.9 + 0.3*308.678 + 0.3*84.363
=430.36 + 92.6034 + 25.3089
=548.3

PV of 25 million:
25/(1.12)
=22.32

so option=38 -22.32
=15.68