3. Place-Plus, a real estate development firm, is considering several alternativ

Question

3. Place-Plus, a real estate development firm, is considering several alternative development projects. These include building and leasing an office park, purchasing a parcel of land and building an office building to rent, buying and leasing a warehouse, building a strip mall, and selling condominiums. The financial success of these projects depends on interest rate movement in the next 5 years. The various development projects and their 5- year financial return (in $1,000,000s) given that interest rates will decline, remain stable, or increase, are in the following payoff table. Place-Plus real estate development firm has hired an economist to assign a probability to each direction interest rates may take over the next 5 years. The economist has determined that there is a 0.45 probability that interest rates will decline, a 0.35 probability that rates will remain stable, and a 0.20 probability that rates will increase. a. Using expected value, determine the best project. b. Determine the expected value of perfect information. Decline Stable Increase Office park $0.4 $1.55 $3.5 Office building 2.5 1.8 2.75 Warehouse 1.7 1.45 1.5 Mall 0.8 2.3 3.5 Condominiums 3.2 1.5 0.5

Explanation / Answer

Expected value = Probability that interest rate will decline * Return if the interest rate will decline + Probability that interest rate will remain stable * Return if the interest rate will remain stable + Probability that interest rate will increase * Return if the interest rate will increase.

Putting the values in the formula, we will achieve the returns as per the following table.

The last column shows the expected value of each outcome. The best project is "Office Building" since its expected return is $2,305,000

B) Expected value of perfect information is the amount that a person is willing to pay to get to get perfect information.

Expected Value of perfect information = Maximum return amonst the projects = $2,305,000

Decline Stable Increase Return (expected value) (in $1,000,000) Office Park 0.4 1.55 3.5 1.4225 Office building 2.5 1.8 2.75 2.305 warehouse 1.7 1.45 1.5 1.5725 Mall 0.8 2.3 3.5 1.865 condominiums 3.2 1.5 0.5 2.065

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