STEP 1: Picture the problem
When it comes to visualizing real options, we are really trying to visualize how the flexibility to alter an investment’s scale, scope, and timing enhances the value of an investment. In effect, visualizing the real options involves trying to look into the future and imagining how the project at hand might be altered to increase its value.
STEP 2: Decide on a solution strategy
Real options arise out of flexibility or opportunities to do different things with an investment over its useful life. So we need to look for the opportunities presented to Imperial Properties in the two properties.
STEP 3: Solve
The primary option presented to Imperial in this situation is the option to develop the properties and change them from two 4-apartment units to two luxury 10-apartment units. However, to exercise this option Imperial must commit to a $1.5 million building program for each building. Moreover, we are left with the impression that Imperial holds the option to develop one or both buildings. This suggests that if the firm undertakes one of the building projects it can defer the second until it sees how the first proceeds.
STEP 4: Analyze
Options add value to projects and generally indicate that static NPV calculations will underestimate the value of the investment opportunity. This results from the fact that where managers have the flexibility (options) to respond to changing economic conditions, they can modify or halt the operation of the investment so as to maximize the value created by the investment.
>> END Solution ST.3
Tools for Analyzing the Risk of Project Cash Flows
13–1. (Related to Checkpoint 13.1 on page 420) (Calculating expected revenues) The owner of the Crusik Distribution Company is evaluating the expected annual sales for a new line of facial care products and estimates that there is a 50% chance that the