Use decision tree analysis to determine the value of the investment timing option.
Use the Black-Scholes Option Pricing (BSOP) model to estimate the value of the investment timing option. Specify the values of input variables used for your application of the BSOP. Explain in detail the procedure of estimating the risk of returns for the underlying asset of the real option.
| Summary of key inputs | |
| Market value of bare land | $15,000,000.00 |
| Gross annual rental income | $600,000 |
| Tax rate | | 28% |
| Set-up cost | | $7,000,000 |
| Annual revenue | Probability | |
| Low demand | 30% | $5,000,000 |
| Medium demand | 40% | $9,000,000 |
| High demand | 30% | $13,000,000 |
| Variable costs | (% of revenue) | 65% |
| Fixed costs | | $2,500,000 |
| Cost of capital | | 10% |
| Risk-free rate | | 3% |
Mainfreight New Zealand is a publicly listed company that offers freight transport and warehousing services locally and abroad through international alliances. Suppose the company owns a piece of land with an old building near the Auckland International Airport. The building and the land have a current appraised market value of $15 million, and the building is currently used as a warehouse generating a perpetual gross annual rent of $600,000. As the rental contract is going to expire soon, the company is considering an option of using the site and the building for an expansion of its logistic business. In that case, the company will need to get the building refurbished and re-configured. The refurbishment and preparation for the logistic business will cost $7,000,000 and take one year to complete. An international logistic company has promised Mainfreight an additional subcontract of $5,000,000 worth of business each year should the company decides to go ahead with the expansion plan. Variable cost of operation is 65% of the annual revenue and the incremental fixed cost is estimated to be $2,500,000 a year. It is also estimated that the business expansion will have a 40 percent chance to generate an additional $4,000,000 local business, and a 30 percent chance to generate an additional $8,000,000 local business, in addition to the incremental subcontract with the international player. The chance of not getting any incremental business from the local market is 30 percent. This project can be delayed for one year, and the cost of expansion, incremental revenue and cost forecasts for different scenarios will remain the same as projected. Suppose the uncertainty about the incremental demand in the local market will only last for one year. As the economic condition stabilizes over the next year, the company will be able to know exactly how high the incremental revenue is going to be at the end of year one. Assume the business expansion, once established, will last forever. The initial cost for setting up the expansion of business can be fully depreciated over 10 years using the straight-line method. The value of land will be preserved at its current market value, but may not be depreciated for tax reasons. Risk-free interest rate is 3 percent (1-yr treasury rate, compounded annually). The corporate tax rate is 28 percent, and the cost of capital is 10%. A summary of the key inputs for project analysis is provided in an Excel file named Case data
