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1. Consider Titmans equation for the real-option value of vacant land. (a) Does the real-option value increase or decrease with a positive change in the
1. Consider Titmans equation for the real-option value of vacant land.
- (a) Does the real-option value increase or decrease with a positive change in the current price of vacant land? Justify your answer.
- (b) Does the real-option value increase of decrease with a positive change in the risk-free rate of return? Justify your answer.
- (c) Does the real-option value increase or decrease with a positive change in the volatility of future prices? Justify your answer.
(d) If a market has experienced a negative external shock, so that property prices fall significantly, are we likely to see an increase or decrease in the rate of new development? Justify your answer.
- 2. Consider the capital structure of an Australian Real Estate Investment Trust (REIT). The cost of equity capital for this REIT is (8% per annum). It has one million shares outstanding and an asset Beta of 1.0. The REIT is currently debt-free, although the current cost of corporate debt is 5% per annum. The REIT has a long history of paying out dividends of $1 per share per annum. The current rate of corporate tax is a flat-rate 30% and the risk-free rate of return is 3% per annum. The REITs assets are expected to exhibit no capital growth over the foreseeable future, but are expected to realise an annual volatility of 25%. The REIT is offered an opportunity to invest in a 50% share of a new corporate office building, having the same risk profile as their current line of business, and requiring an upfront investment of $10 million. The REIT can finance this investment via a bank loan, or via a seasoned equity offering. Advise the REIT on the financing choice that maximises the returns to equity holders.
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