A real estate investor has the opportunity to purchase land currently zoned resi
ID: 452431 • Letter: A
Question
A real estate investor has the opportunity to purchase land currently zoned residential. If the county board approves a request to rezone the property as commercial within the next year, the investor will be able to lease the land to a large discount firm that wants to open a new store on the property. However, if the zoning change is not approved, the investor will have to sell the property at a loss. Profits (in thousands of dollars) are shown in the following payoff table:
If the probability that the rezoning will be approved is 0.5, what decision is recommended?
Recommended decision: Purchase
What is the expected profit?
Expected profit: $
The investor can purchase an option to buy the land. Under the option, the investor maintains the rights to purchase the land anytime during the next three months while learning more about possible resistance to the rezoning proposal from area residents. Probabilities are as follows:
What is the optimal decision strategy if the investor uses the option period to learn more about the resistance from area residents before making the purchase decision?
High resistance: Do not purchase
Low resistance: Purchase
If the option will cost the investor an additional $10,000, should the investor purchase the option?
Yes
Why or why not?
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What is the maximum that the investor should be willing to pay for the option?
EVSI: $
Explanation / Answer
a) If the probability that the zoning will be approved is 0.5, what decision is recommended? ____d1 (purchase) the property
What is the expected profit? = .5(610)+.5(-190) = $210,000.
b.
If there is high resistance? __Max of -56 and 0 so 0 which is d2 do not purchase
If there is low resistance? Max of 512 and 0 so 512 which is d1 purchase
The expected value if purchasing the option? =.55x0 + .45x512 = $230,400
EVSI=230,400 – 200,000 = $30,400. As option costs $10,000 it should be purchased as it improves the value by 30,400$
What is the maximum that the developer should be willing to pay for the option?
Up to $30,400.
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