Larry Yung, Chairman of Citic Pacific Limited, has a decision to make. He must decide if he should invest in property and build the “Citic Tower II”. Under the current conditions, the current net present value is negative, which is one of the factors that Larry is using to decide. Another concern is that the commercial real estate market is very cyclical in the area. Also, with the current economic conditions, there is not really a guarantee that the “Citic Tower II” will survive in the area, which another concern for Larry Yung.
In terms of the positives for this investment, the location of this building is prime as it is located attracted the banking and financial sectors, and special accounting and legal firms. Also, Citic Tower has maintained its occupation rate, according to the case, even after the economic crisis that hit Asia. After seeing these benefits and concerns of this property, Larry Yung must decide if his company wants to invest in the property.
As net present value is a factor that Larry Yung uses to make decision; it has to reflect a positive number in order for him to convince the board with a go-head to the project. Under the condition where there is no flexibility, managerial discretion or strategic actions, the net present value of the project will solely be the present value of cash flow subtracts the cost of the project. In numerical term, the asking price of HK$ 1 billion dollar has a present value of HK$ 1. 54 with a cost of HK$ 1. 6 billion.
This leads to a net present value of HK$ (60 million) dollar. This makes the project very unattractive. Therefore, different approach is used to examine whether or not the project is profitable. Weighted average cost of capital is used in the discounted cash flow method that shows the case of Citic Tower II becomes more attractive. Based on the DCF analysis stated in figure 1, the option to defer development for 6 months provides Citic Pacific Limited (CFL) with the greatest opportunity. The 12 month deferred payment provides CFL with a cost benefit of $171,266. 3, while at the same time allowing the firm to access the market risk during those first 12 months. Because of the volatility in the Hong Kong real estate market, this option best hedges against any extreme changes in the real estate market by allowing the 12 months grace period in which the firm can decide to pull out of the deal. If the seller were allowed to take a 5% equity stake in the project (5% of HK 1. 54 Billion) with the exclusive option including deferment of purchasing the land for 12 months, then the value of the option would outweigh its cost.
Typically if there is a long-time before you must exercise an option then the value of this real option will increase if the market or conditions are expected to improve. The 5% equity stake will cost the firm HK 77 Million, but the value added in this option being (P0/1+r)+((FCF1/(1+WACC)^2)) with our new Risk-Free Rate of 3. 8% with the purchase option deferred to mid-2001 our new expected NPV of: HK$ 2. 36 Billion. There are some other factors that make the option attractive as well.
For instance, Citic Pacific Limited has had impressive improvements in their production development teams so that would be very useful for the “Citic Tower II”. With the increased performance and expertise for the teams, building the project can take even less time, as the first tower only take two years. Also, as discussed above by waiting to defer the project, Citic Pacific Limited prevents itself from the negative cash flows in the early years. By refinancing, the seller’s price is boosted and it gives the company and CPL to negotiate better terms. These are the factors that make the option attractive.