Question 1

Dash plc, a property development and investment company, is considering purchasing a disused airfield site to develop as a retail park. The purchase price of the land is 2.3 million. Dash would need to spend an additional 6 million now to develop the site. The project will generate cash flows from rental income every year in perpetuity. If the local government builds a new road nearby, the yearly cash flows will be 1.1 million (probability 0.5). If the new road is not built, the yearly cash flows will be 180,000 (probability 0.5). The first cash flow will occur in one year.

Assume that 8% is a suitable discount rate for all cash flows.

(a) What is the expected net present value of the project? (5 marks)

Suppose that Dash can sell the developed site, if it chooses to do so, after one year for 10 million.

(b) What is the expected value now of this abandonment option? Is the project worthwhile?

Assume now that, if the site is not sold, Dash can instead choose to invest 3 million in one year to expand its retail space. The expansion will result in additional rental cash flows of either 168,000 every year (probability 0.25) or 354,000 every year (probability 0.75) in perpetuity, depending on whether a large department store chooses to occupy the new space after it is built. The first cash flow from the expansion will occur in two years.

(c) What is the expected value now of the expansion option?

(d) Suppose that the project cannot be delayed, but Dash can purchase the land now and own it without further investment for up to one year, by paying a fee to the local government. If Dash believes that the land could be sold for 4.5 million in one year, what is the maximum fee the firm would pay now?