Larry Young the Chairman of Citic Pacific Limited has to do a determination to develop a new undertaking under the name Citic Tower II. The development undertaking that will take topographic point in Hong Kong is expected to go forth the company with $ 60 MM in losingss as per NPV analysis. Citic’s belongings development squad has set stiff premises to construct their NPV theoretical account that estimated net positive hard currency influxs at $ 1. 54 billion and entire costs of ? $ 1. 6 billion including land that worth $ 1 billion. The NPV theoretical account underlying premises didn’t to the full capture the upward potency of the additions that might be acquired from developing the undertaking if the economic environment was to better. However. the downside hazard is presently feasible as per the NPV is the negative zone.
Therefore. the ultimate final payment form to CPL is to prosecute in an option that will let the company to better its apprehension of the possible losingss or net incomes and it will enable the company to capture upside possible net incomes and chasten its losingss to the value of the option. The mentioned option has the same final payment of a European Call Option as shown in the above diagram. The option is to postpone the determination to get down developing by one twelvemonth. The existent option from the marketer point of position is to sell the land in 1 twelvemonth to CPL for the same value. The marketer valued the option as 5 % of the undertaking value. CPL’s rating of the option will find either to take the option or non. The marketer priced the option to buy the land at:
5 % * $ 1. 600. 000. 000 = $ 80. 000. 000CPL Option Pricing:CPL determination to purchase the option will depend on ciphering the theoretical monetary value of the option and compare it to the existent monetary value of the option offered by the marketer. As mentioned earlier. the final payment form of the proposed option resembles the final payment of long European Call option from CPL’s point. Therefore. CPL should utilize Black-Scholes option pricing theoretical account to make a theoretical monetary value to find the economic feasibleness of the option. Black-Scholes theoretical account for long call option is: The rating in conformity to the equation above consists of the undermentioned variables: C = name monetary value
S = plus monetary value $ 1. 540. 000. 000K = work stoppage monetary value $ 1. 600. 000. 000R = hazard free funding rate as of December 2000 5. 38 %T = clip of the option 1 YearSigma = volatility of the plus ( utilizing the class A office monetary value index for the old 15 old ages ) 10. 77 % quarterly and 21. 55 % annualized. The call monetary value for CPL is equal to $ 143. 351. 120 given the above mentioned premises. CPL determination and decision:
The current option offered by the marketer is $ 80 MM and extra 50 % professional design and preparatory work that will be done during the option life ; the extra cost is estimated to be $ 22 MM and should exceed the original sum of the option cost. The entire option cost is $ 102 MM compared to theoretical option monetary value of $ 143 MM with a difference of $ 41 MM. The theoretical option monetary value is non 100 % accurate as the development costs are assumed to take topographic point at the terminal of twelvemonth 2 and twelvemonth 3 which is non the existent instance scenario as they are supposed to be in S-Curve shaped payment. This consequence decreased the existent monetary value of the option and besides increased the theoretical monetary value. Therefore. CPL should negociate with the marketer to diminish its option monetary value to 4 % alternatively of 5 % but still put to death the option.