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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.

  1. (a) Does the real-option value increase or decrease with a positive change in the current price of vacant land? Justify your answer.
  2. (b) Does the real-option value increase of decrease with a positive change in the risk-free rate of return? Justify your answer.
  3. (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.

  1. 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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