Digunder, a property development company, has gained planning permission for the development of a housing complex at Newtown which will be developed over a three year period. The resulting property sales less building costs have an expected net present value of $4 million at a cost of capital of 10% per annum. Digunder has an option to acquire the land in Newtown, at an agreed price of $24 million, which must be exercised within the next two years. Immediate building of the housing complex would be risky as the project has a volatility attaching to its net present value of 25%. One source of risk is the potential for development of Newtown as a regional commercial centre for the large number of professional firms leaving the capital, Bigcity, because of high rents and local business taxes. Within the next two years, an announcement by the Government will be made about the development of transport links into Newtown from outlying districts including the area where Digunder hold the land option concerned. The risk free rate of interest is 5% per annum.

Required

(a)Estimate the value of the option to delay the start of the project for two years using the Black and Scholes option pricing model and comment upon your findings. Assume that the Government will make its announcement about the potential transport link at the end of the two-year period. (12 marks)

(b)On the basis of your valuation of the option to delay, estimate the overall value of the project, giving a concise rationale for the valuation method you have used. (3 marks)

(c)Describe the limitations of the valuation method you used in (a) above and describe how you would value the option if the Government were to make the announcement at anytime over the next two years. (5marks) (Total = 20 marks)