Explore BrainMass
Share

Conceptual Analysis of Real Options

This content was STOLEN from BrainMass.com - View the original, and get the already-completed solution here!

Highland properties owns two adjacent four-unit apartment buildings that are both on 20,000 square feet of land near downtown Portland, Oregon. One of the properties is in very good condition, and the apartment can be rented for $2,000 per month. The unit in the other property requires some refurbishing and in their current condition can be rented for only about $1,500 per month.
Recent zoning changes, combines with changes in market demand, suggest that both lots can be redeveloped. if they are redeveloped, the existing unit would be torn down and new luxury apartment buildings would be build on the site, each with 10 apartments units. The cost of the 10-unit buildings is estimated to be about $1.5 million, and each of the 10 apartments can be rented for $2,500 per month under current market conditions. Similar properties that have been refurbished are selling for 10 times their annual rentals.

a. Identify the real option(s) in this example.
b. What are the basic elements of options(s) (i.e., the underlying asset on which the option is based, the expiration date, and the exercise price)?
c. Estimate the value of the option to develop the property.

© BrainMass Inc. brainmass.com October 25, 2018, 6:41 am ad1c9bdddf
https://brainmass.com/business/real-options-valuation/conceptual-analysis-of-real-options-471978

Attachments

Solution Preview

a. You have a call option here. If Sale value of new property is greater than construction cost, then ...

Solution Summary

Highland properties owns two adjacent four-unit apartment buildings that are both on 20,000 square feet of land near downtown Portland, Oregon. One of the properties is in very good condition, and the apartment can be rented for $2,000 per month. The unit in the other property requires some refurbishing and in their current condition can be rented for only about $1,500 per month.
Recent zoning changes, combines with changes in market demand, suggest that both lots can be redeveloped. if they are redeveloped, the existing unit would be torn down and new luxury apartment buildings would be build on the site, each with 10 apartments units. The cost of the 10-unit buildings is estimated to be about $1.5 million, and each of the 10 apartments can be rented for $2,500 per month under current market conditions. Similar properties that have been refurbished are selling for 10 times their annual rentals.

a. Identify the real option(s) in this example.
b. What are the basic elements of options(s) (i.e., the underlying asset on which the option is based, the expiration date, and the exercise price)?
c. Estimate the value of the option to develop the property.

$2.19
See Also This Related BrainMass Solution

Current trends in macro and microeconomics

We make choices as consumers every day. Opportunity cost is defined as a person's "next best alternative" or "the cost of what you give up when you make a choice."

Think of a recent decision you made regarding your career. What was your opportunity cost for making that choice? What was your "next best alternative"?

Objective: Identify current trends in macro and microeconomics.
Use supply and demand to analyze business activities to formulate business plans.

Instructor Comments:
To complete this IP, consider the standard house, 3-bedroom, 2-bath house. Compare this standard house in different locations in the US by collecting the price information. The differences in the price of "same house" in different locations can be explained using demand and supply. ("location" is NOT an answer to this IP)

The housing price is determined by demand and supply of housing. State the determinants of demand and of supply that are consistent with economic theory and are plausible. (1) The determinants of demand are the factors that affect the decision to buy s house and the maximum price that the buyer will pay. (2) The determinants of supply are the factors that affect the decision to sell another unit and the minimum price that the seller will accept. The learning objective is to demonstrate the proper use of concepts in market analysis. In particular there should be a discussion on how the market responds to excess demand and a discussion on how the market responds to excess supply. Excess demand and excess supply are generated if demand or supply shifts. There should be a discussion on how changes in determinants of demand and changes in the determinants of supply affect the housing market. Excess demand and excess supply should be included in your analysis.

Warning and suggestion: you are not required to "prove" or justify your selection of the determinants of demand and supply. But your discussion and selection of a factor or a determinant must be reasonable and plausible.

View Full Posting Details