Real Estate Investment class 3. X-real Inc. is analyzing a new office building p
ID: 2801040 • Letter: R
Question
Real Estate Investment class
3. X-real Inc. is analyzing a new office building project that would require an investment of $60 million. If the market was good, it would produce cash flows of $18 million a year for 8 years, but if the market did not like it, then the cash flows would be only $6 million per year. There is a 50 percent probability of both good and bad market conditions. X-real could delay the project for one year to determine if demand would be strong or weak. X-real’s WACC is 10 percent. What is the value of the timing option?
Explanation / Answer
After one year if demand is strong, NPV1 year later=-60+18/0.1*(1-1/1.1^8)=36.02867 million
After one year if demand is weak, NPV 1 year later=-60+6/0.1*(1-1/1.1^8)=-27.9904 million
As we know that in case of weak demand, being a negative NPV we will not invest in the project. Hence, timing option value=0.5*36.02867/1.1=16.37667
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