Question

J&R Construction Company is an international conglomerate with a real estate division that owns the right to erect an office building on a parcel of land in downtown Sacramento over the next year. This building would cost $37 million to construct. Due to low demand for office space in the downtown area, such a building is worth approximately $35 million today. If demand increases, the building would be worth $39.5 million a year from today. If demand decreases, the same office building would be worth only $33 million in a year. The company can borrow and lend at the risk-free annual effective rate of 2.2 percent. A local competitor in the real estate business has recently offered $805,000 for the right to build an office building on the land. What is the value of the office building today? Use the two-state model to value the real option.

Answer 1