Real option analysis: Invest now or wait and see?

Private investors are considering whether to open a mid priced restaurant within a new condominium complex that is also located near a shopping district. The ’Peloton Café’ investors expect that their café will capture 30% of this locale’s dining market. The investors are concerned that a national chain restaurant might open nearby and reduce Peleton’s share by half.

The investors believe there is a 50:50 chance that the chain restaurant may decide to locate nearby. They do not believe the existence of the Peloton Café will affect the chain’s decision.

They may wish to wait one year before deciding to determine whether the chain restaurant decides to locate nearby. Whenever the decision is made, the investors expect to be able to terminate their investment after the first year of operation, probably at a loss. The following table contains data that are relevant to this investment decision.

Required:

1. Evaluate the Peloton Café investment as a real option. Should the investors act now or wait? Up to what amount would the investors be willing to pay for an option on this restaurant space. Explain.

2. Explain and describe the sources and impacts of risk in this decision.

Transcribed Image Text:

Caf investment data values First year s mar et Annual mar et ro th ar et share ithout Chain ar et share ith Chain Gross mar in ratio Discount rate Investment cost Investment life, years Salva e value at end of life 4,000,000 6 30 15 40 8 800,000 4 0 35 ax rate Depreciation strai ht line Sales and administrative costs 200,000 160,000 Probability of Chain entry 50 Sale on early termination 400,000 Reinvestment cost to extend life 1 year 300,000