ABC Construction, Inc., is currently considering developing, on a piece of land currently held by the company, a new courtyard motel. This project would provide a single payoff from a buyer in one year (after construction was completed).

The concept of a courtyard motel is relatively new; so there is a certain amount of risk associated with this project. The company's management feels that new information regarding potential consumer demand would be revealed, that is, whether in the chosen geographic location a courtyard motel would be popular ("good news") or unpopular ("bad news"). You anticipate a selling price of $13 million in the former case while a selling price of only $9 million in the latter case. At present, these two outcomes are considered equally likely. For projects of this sort, the company uses a WACC (discount rate) of 10% after tax. The company estimates that the total construction costs for this project would, in today's dollars, be approximately $9.7 million.

Tasks:

Answer the following questions:

• Examine the given probabilities for the two possible outcomes including the expected NPV of the proposed investment.
• Compare real options with financial options.
• Explain what other types of real options can be embedded in a capital investment proposal, and how these classes relate to put options and call options.