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Final exam problem sets after mid-term 1. REAL OPTIONS I -- GROWTH OPTIONS: Jayhawk Co. is deciding whether to proceed with Project X. The cost would be $18 million in Year 0. There is a 70 percent chance that X would be hugely successful and would generate annual after-tax cash flows of $12 million per year during years 1, 2, and 3. However, there is a 30 percent chance that X would be less successful and would generate only $4 million per year for the 3 years. If project X is hugely successful, it would open the door to another investment, Project Y, that would require a $10 million outlay at the end of Year 2. Project Y would then be sold to another company at a price of $14 million at the end of Year 3. Jayhawk's WACC is 10 percent. If the company does not consider real options, what is Project X's NPV? What is X's NPV considering the growth option? What is the value of the growth option? 2. REAL OPTIONS II -- ABANDONMENT OPTIONS: Coconut Bay LLC., is considering buying a vacant lot that sells for $28.2 million. If the property is purchased, the company's plan is to spend another $85 million today (t = 0) to build a resort hotel on the property. The after-tax cash flows from the hotel will depend critically on whether the state increases the tourism tax in this year's legislative session (50% chance). If the tax is increased, the resort is expected to produce after-tax cash inflows of $10,000,000 at the end of each of the next 20 years. If the tax is not altered, the hotel is expected to produce after-tax cash inflows of $20,000,000 at the end of each of the next 20 years. The project has a 12 percent WACC. While the company does not have an option to delay construction, it does have the option to abandon the project 1 year from now if the tax is imposed. If it abandons the project, it would sell the complete property 1 year from now at an expected price of $100 million. Once the project is abandoned the company would no longer receive any cash inflows from it. What is the value of this abandonment option? Solution: 3. REAL OPTIONS - INVESTMENT TIMING OPTIONS Donovan Developers Inc. is considering a new project that would require an investment of $50 million. If the project were well received, it would produce cash flows of $18 million a year for 5 years, but if the market did not like it, then the cash flows would be only $6 million per year. There is a 50 percent probability of both good and bad market conditions. Donovan could delay the project for a year while it conducts a test to determine if demand would be strong or weak. Donovan's WACC is 12 percent. What action would you recommend? Why (i.e., quantitatively justify your recommendation)? Without timing option: 4. Suppose reits A borrows at 7%, The debt/equity ratio of reits A is 4/6, reits A have return on equity of 16%. Calculate cost of capital of the reits? 5. Suppose we can observe the total return of the office building is 10%. We know the LTV of a specific building is 0.7. The loan rate is 8%. What is the expected return of the equity on this property? 6. Tom learns that the market value of his house is $325,000 now. Considering his wage increases to a level that he can support another mortgage, he wants to invest in housing market. So he decides to do cash out refinance. The current mortgage balance is $170,000. Assume his mortgage LTV is 80%. 1) How much he can cash out? 2) He wants to use the cash out fund to support a new house. He doesn't worry about future mortgage payment. Suppose his new mortgage LTV=80% as well. His moving in cost (except down payment) is $50,000. What is the highest house price that he can buy? 7. Atlantis REIT expects an income of $9.00 per share. This includes a deduction of $2.00 per share for depreciation. Atlantis did not have any gains from the sale of real estate. Its properties are mainly apartments, and you believe that apartments are currently selling on average at about an 8 percent cap rate. Atlantis has 1 million shares outstanding and its balance sheet shows liabilities of $40 million. Comparable REITs have FFO multiples of about 10. Atlantis is expected to pay a dividend during the next fiscal year of $5.50 per share and to increase those dividends at about 2 percent per year in the future. Investors in REITs like Atlantis usually expect a return of about 10 percent. a. What is the FFO and value per share based on an FFO multiple? b. What value per share is indicated using a dividend discount model? c. What is the value per share implied by the net asset value of the properties