It was three o' clock on a hot afternoon in Hong Kong in mid-2000. Larry Yung, Chairman

of Citic Pacific Limited ("CPL"), was having a board meeting with his property development

team. From his window on the 33rd floor of Citic Tower, he could see the impressive Victoria

Harbour and an undeveloped prime waterfront site. This piece of reclaimed land had been

purchased by a company six months earlier at a public auction. Now, the owner wanted to

dispose of it, and hence it was made available to CPL on a first-choice basis through an

intermediary. Larry thought CPL could acquire the site and develop it into another Grade A

office building in Central he planned to call it "Citic Tower II". The asking price of the

land was HK$1 billion, and the estimated scale of the building and development costs were

comparable to those of Citic Tower. Larry personally wanted to give this deal the go-ahead,

but he was hesitant to commit his company to this two-to-three year project without seeking

advice from his management team.

At the board meeting, Larry leaned back in his chair and riffled through the feasibility report

he had been given. To his disappointment, investing in Citic Tower II did not seem to bring

about clear positive returns. Under the rigid assumptions set by the property development

team and the Net Present Value Rule, the project reflected a present value of around HK$1.54

billion and a cost of around HK$1.6 billion. Larry intuitively felt that the decision was too

deterministic, as it did not allow for any flexibility, managerial discretion or strategic actions.

Should he allow the board to reject or go ahead with this project based on discounted

cashflow (DCF) analysis alone? If the decision to develop was delayed or otherwise changed,

would the full potential of this development opportunity be substantially better than the

analysis suggested?

Background

Citic Pacific Limited was incorporated in Hong Kong and listed on the Hong Kong Stock

Exchange in 1991. In 2000, infrastructure and related assets formed the cornerstone of CPL's

activities, ranging from civil facilities such as complex bridge, road and tunnel facilities to

power generation, environmental projects, aviation and telecommunications. CPL owned

extensive trading and distribution interests, particularly in the motor industry, through its wholly owned subsidiary, Dah Chong Hong Limited. It also had stakes in firms such as

Cathay Pacific, Dragonair and a string of trading and property companies.

Given the cyclical nature of the market, CPL's property revenues were significantly less

predictable than the revenues from the company's infrastructure assets, where high

proportions of its revenues were contractually defined and recurrent. Property investment

projects were generally based on 12 per cent required return on investment based on CLP's

weighted average cost of capital (WACC), with no attempt to differentiate for individual

project risk in WACC. Over time, CPL's property development team had gained extensive

expertise and knowledge in the property business. The development of Citic Tower, which

began in August 1995, and completed in less than two years, represented an impressive

achievement in development management. As at 1999, despite the property market being

affected by the post-Asian financial crisis, weak demand and falling prices, Citic Tower still

maintained a relatively high occupancy rate.

Larry knew that the commercial real estate market was extremely cyclical, and that very few

companies active in the market had managed to time rental cycles and investment strategy

successfully (Exhibit 1 shows the Grade A office rental and capital value time series from

1986 to 2001, and Exhibit 2 provides information on recent risk-free rates in Hong Kong).

Although Citic Tower I had managed to survive the economic downturn unscathed, there was

no guarantee that things would be any easier for Citic Tower II. Given the volatile nature of

the market, the mark of a successful project was when the developer knew when to pull in the

reins and when to let them out.

With this in mind, Larry thought the outlook for the project could change if it could be

deferred or otherwise re-scaled. With a possible negative net present value, launching the

project at this point was unambiguously sub-optimal. However, things could change over

time. At some point, the property market could be on the upturn again. If Citic Tower II

came onto the market at the right time, it might be far more promising than it appeared in

mid-2000.

The Real Option

Larry's doubts about the rigid application of the DCF analysis led to more discussions on the

alternatives available surrounding the development of Citic Tower II. At the end of the

meeting, Larry was glad that the board did not reject the proposal. In fact, as the debate flared

up, members of the property development team floated some useful ideas.

Early investment in the Citic Tower II project meant sacrificing the option to defer the

decision to go ahead immediately, which was valuable because of high uncertainties and the

long investment horizon associated with the property development industry. One member

therefore suggested that the company acquire the rights to the land, and thus the development,

by offering to purchase an exclusive option from the seller. The option to purchase the land

would allow CPL to defer the decision to develop for one year. Such an option was also not

without risks. If the project was truly a winner, waiting would mean loss or deferral of its

early cashflows. However, since the project did not appear to be clearly attractive at this

point, waiting could prevent a big mistake. On this point all members of the board were in agreement. The question, however, was how to lure the seller to accept such an

offer.

Negotiations

Three years earlier, land owners would not have even considered negotiating an option to

purchase development sites. At that time, commercial development sites were keenly sought after despite the high land prices. Demand for office space in Central was particularly strong,

as its prime location attracted the banking and financial sectors, major accountancy and legal

firms as well as regional headquarters of multinational corporations. Multiple offers and

aggressive bids were often found at land auctions. However, as the market cooled after the

Asian financial crisis, that scenario was no longer the case. Property developers seemed to be

more cautious than before, and most preferred to stay on the sidelines.

Given the present economic climate, CPL was hoping that the seller would grant CPL an

option to defer purchase of the land, exercisable at the end of one year, thereby allowing CPL

to defer the whole project for one year. Two weeks earlier, the seller had reached a new

agreement with its banker to restructure its HK$3 billion debts, thereby alleviating its short term

cashflow problems. Under the agreement, the repayment would be extended from two

years to three years, including a grace period of 12 months. The refinancing not only

provided a big boost to the seller's share price, but it would also better position both the

company and CPL to negotiate more flexible terms for the land sale.

CPL's early talks with the seller were encouraging. The seller had shown an interest in

granting an exclusive option for 12 months. However, as the price of the option, it had

requested an equity stake of 5% in the completed project.

The Decision

Larry sat at his desk overlooking the newly reclaimed land on the waterfront of Victoria

Harbour. He was a little perplexed about the decision in front of him. The exclusivity option

offered additional choices, but at the same time it was difficult to assess. Should CPL accept

the terms proposed by the seller? Larry sighed, picked up his jacket and headed for the last

board meeting in July. He wondered whether his property development team would still

reject the project after two weeks' study of this decision.

i) What are the values of S, K, t, sigma and risk-free rate for the option involved? Show calculations (e.g., sigma) for each variable, if required.

ii) What kind of option (call/put, long/short) is involved? Briefly discuss how you decided this (i.e., compare option characteristics to the case).