# InstructionsTasks:Answer the following questions:Examine the given probabilities for the two possible outcomes including the expected NPV of the proposed investment.Compare real...

## Instructions

• Examine the given probabilities for the two possible outcomes including the expected NPV of the proposed investment.

• Compare real options with financial options.

• Explain what other types of real options can be embedded in a capital investment proposal, and how these classes relate to put options and call options.

Case 2

Miller Stores operates a regional chain of upscale department stores. The company is going to open another store soon in a prosperous and growing suburban area. When discussing how the company can acquire the desired building and other facilities needed to open the new store, two company officers—Harry Wilson (the company's marketing vice president) and Erin Reilley (the company's executive vice president)—had the following conversation:

Wilson:

I know most of our competitors are starting to lease facilities, rather than buy, but I just can't see the economics of it. Our development people tell me that we can buy the building site, put a building on it, and get all the store fixtures we need for \$14 million. They also say that property taxes, insurance, maintenance, and repairs would run \$200,000 a year. When you figure that we plan to keep a site for twenty years, that's a total cost of \$18 million. But then, when you realize that the building and property will be worth at least \$5 million in twenty years, that's a net cost to us of only \$13 million. Leasing costs a lot more than that.

Reilley:

I'm not so sure Guardian Insurance Company is willing to purchase the building site, construct a building, and install fixtures to our specifications, and then lease the facility to us for twenty years for an annual lease payment of only \$1 million.

Wilson:

That's just my point. At \$1 million a year, it would cost us \$20 million over the twenty years instead of just \$13 million. And what would we have left at the end? Nothing! The building would belong to the insurance company! I'll bet they would even want the first lease payment in advance.

Reilley:

That's right. We would have to make the first payment immediately and then one payment at the beginning of each of the following nineteen years. However, you're overlooking a few things. For one thing, we would have to tie up a lot of our funds for twenty years under the purchase alternative. We would have to put \$6 million down immediately if we buy the property, and then we would have to pay the other \$8 million off over four years at \$2 million a year.

Wilson:

But that cost is nothing compared to \$20 million for leasing. Also, if we lease, I understand we would have to put up a \$400,000 security deposit that we wouldn't get back until the end. And besides that, we would still have to pay the entire repair and maintenance costs, just as though we owned the property. No wonder those insurance companies are so rich if they can swing deals like this.

Reilley:

Well, I'll admit that I don't have all the figures sorted out yet, but I do have the operating cost breakdown for the building, which includes \$90,000 annually for property taxes, \$60,000 for insurance, and \$50,000 for repairs and maintenance. If we lease, Guardian will handle its own insurance costs and will pay the property taxes, but we'll have to pay for the repairs and maintenance. I need to put all this together and see if leasing makes any sense with our 12% before-tax required rate of return. The president wants a presentation and recommendation in the executive committee meeting tomorrow.

• Using the NPV approach, determine whether Miller Stores should lease or buy the new store.

• Discuss how you will reply in the meeting if Wilson brings up the issue of the building's future sales value. Provide a brief description with supporting information.

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Case 1

ABC Construction, Inc., is currently considering developing, on a piece of land currently held by the company, a new courtyard motel. This project would provide a single payoff from a buyer in one year (after construction was completed).
The concept of a courtyard motel is relatively new; so there is a certain amount of risk associated with this project. The company's management feels that new information regarding potential consumer demand would be revealed, that is, whether in the chosen geographic location a courtyard motel would be popular ("good news") or unpopular ("bad news"). You anticipate a selling price of \$13 million in the former case while a selling price of only \$9 million in the latter case. At present, these two outcomes are considered equally likely. For projects of this sort, the company uses a WACC (discount rate) of 10% after tax. The company estimates that the total construction costs for this project would, in today's dollars, be approximately \$9.7 million.

• Examine the given probabilities for the two possible outcomes including the expected NPV of the proposed investment.

• Compare real options with financial options.

• Explain what other types of real options can be embedded in a capital investment proposal, and how these classes relate to put options and call options.

Case 2

Miller Stores operates a regional chain of upscale department stores. The company is going to open another store soon in a prosperous and growing suburban area. When discussing how the company can acquire the desired building and other facilities needed to open the new store, two company officers—Harry Wilson (the company's marketing vice president) and Erin Reilley (the company's executive vice president)—had the following conversation:

Wilson:I know most of our competitors are starting to lease facilities, rather than buy, but I just can't see the economics of it. Our development people tell me that we can buy the building site, put a building on it, and get all the store fixtures we need for \$14 million. They also say that property taxes, insurance, maintenance, and repairs would run \$200,000 a year. When you figure that we plan to keep a site for twenty years, that's a total cost of \$18 million. But then, when you realize that the building and property will be worth at least \$5 million in twenty years, that's a net cost to us of only \$13 million. Leasing costs a lot more than that.

Reilley:I'm not so sure Guardian Insurance Company is willing to purchase the building site, construct a building, and install fixtures to our specifications, and then lease the facility to us for twenty years for an annual lease payment of only \$1 million.

Wilson:That's just my point. At \$1 million a year, it would cost us \$20 million over the twenty years instead of just \$13 million. And what would we have left at the end? Nothing! The building would belong to the insurance company! I'll bet they would even want the first lease payment in advance.

Reilley:That's right. We would have to make the first payment immediately and then one payment at the beginning of each of the following nineteen years. However, you're overlooking a few things. For one thing, we would have to tie up a lot of our funds for twenty years under the purchase alternative. We would have to put \$6 million down immediately if we buy the property, and then we would have to pay the other \$8 million off over four years at \$2 million a year.

Wilson:But that cost is nothing compared to \$20 million for leasing. Also, if we lease, I understand we would have to put up a \$400,000 security deposit that we wouldn't get back until the end. And besides that, we would still have to pay the entire repair and maintenance costs, just as though we owned the property. No wonder those insurance companies are so rich if they can swing deals like this.

Reilley:Well, I'll admit that I don't have all the figures sorted out yet, but I do have the operating cost breakdown for the building, which includes \$90,000 annually for property taxes, \$60,000 for insurance, and \$50,000 for repairs and maintenance. If we lease, Guardian will handle its own insurance costs and will pay the property taxes, but we'll have to pay for the repairs and maintenance. I need to put all this together and see if leasing makes any sense with our 12% before-tax required rate of return. The president wants a presentation and recommendation in the executive committee meeting tomorrow.

• Using the NPV approach, determine whether Miller Stores should lease or buy the new store.

• Discuss how you will reply in the meeting if Wilson brings up the issue of the building's future sales value. Provide a brief description with supporting information.

Jun 25, 2023
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