Can you see a problem with producing an average figure? Look back at Example 5.4. What strikes you about the average figure that has been calculated?

Example 5.4

Patel Properties Ltd has the opportunity to acquire a lease on a block of apartments that has only two years remaining before it expires. The cost of the lease would be £1,000,000.
The occupancy rate of the block of apartments is currently around 70 per cent and the apartments are let almost exclusively to naval personnel. There is a large naval base located nearby and there is little other demand for the apartments. The occupancy rate of the apartments will change in the remaining two years of the lease depending on the outcome of a defence review.
The navy is considering three options for the naval base:
■ Option 1. Increase the size of the base by closing down a naval base in another region and transferring the naval personnel to the base located near to the apartments.
■ Option 2. Close down the naval base near to the apartments and leave only a skeleton staff there for maintenance purposes. The personnel would be moved to a base in another region.
■ Option 3. Leave the naval base open but reduce staffing levels by 50 per cent.
The directors of Patel Properties Ltd have estimated the following net cash flows for each of the two years under each option and the probability of their occurrence:

The sum of the probabilities is 1.0 (that is, it is certain that one of the possible options will arise).
The business has a cost of capital of 10 per cent.
Should the business purchase the lease on the block of apartments?

Transcribed Image Text:

Option 1 Option 2 Option 3 800,000 120,000 400,000 Probability 0.6 0.1 0.3 1.0