22. Merriwether Developers, which has a 10% required rate of return, has the opportunity to purchase a parcel of land for $1,200,000, a bargain because the land is not zoned. If Merriwether does not take the opportunity, another firm will. The land is scheduled for a zoning hearing a year from now. If the land is zoned as residential, it will be worth $1,300,000 immediately after zoning. In this case, Merriwether could build an apartment complex at a cost of $2,000,000. If the land is zoned as commercial, it will be worth $2,200,000 immediately after zoning. In this case, Merriwether could build a strip mall at a cost of $2,500,000. Either development would be completed 1 year after zoning. Both would be expected to have a life of 10 years once completed. The apartment complex would bring in annual revenues of $675,000 and incur annual costs of $135,000. A rival developer is considering building a shopping center near the land in 5 years. If the shopping center is not built, the strip mall would bring in average annual revenues of $2,500,000 and incur average annual costs of $1,750,000. If the shopping center is built, it would dilute the market, and the strip mall would bring in average annual revenues of $1,800,000 and incur average annual costs of $1,180,000 after the competitor enters the market (starting in Year 6). Merriwether’s best estimate is that there is a 70% chance that the land will be zoned as commercial, and a 35% chance that the rival developer will build the shopping center. Merriwether can sell the land at any point for the value mentioned above ($1,200,000 before zoning, $1,300,000 after zoning if zoned residential, $2,200,000 if zoned commercial);

any development of the land would not affect its value if it is sold.

Expected Value Analysis (Note: The initial cost of the land should not be included.)

1. Find the expected present value of the land without any developments.

2. Find the expected value of the future cash flows associated with

a. The apartment complex.

b. The strip mall.

c. The development overall.

3. Find the value of the project using real options analysis.
4. Find the value of the real options associated with the project.