Question

We have the chance of investing $150,000 today, and have immediate access to a new shopping center in Long Island that promises to be a good deal. You can rent that shopping center for $10,000 this year. Next year (and forever after that) it can either go up to $15,000, or if your competitor buys the mall next door the rent will go down to $5,000. The cost of managing the property is negligible once we make the investment. The CFO says the probability that the rent will go up is 50%. He also tells us that the interest rate is 5%

1. a) Would you invest today or next period? Justify your answer numerically. (Hint: No clear calculations, no credit. 5 points)

2. b) How much are you willing to pay for the flexibility of being able to choose between investing today or tomorrow, instead of having a now or never choice? (5 points)

3. c) Can you find how high the initial investment has to be for the project that allows for a delay such that you would be indifferent between investing today and waiting until next period? (Hint: Remember that you have to use the NPV of the original project to answer this question. 5 points)

Answer 1

a). Cost of investing today= $150000

next year = 50/100*15000+50/100*5000=$10000

second option: 10000+10000/(1+r)+.......

NPV of second option= 10000/0.05= $200000 (using sum of geometric progression)

$150000<$200000

Therefore it is better to invest today.

b). 200000-150000= $50000 The difference between the two options is the amount to make these two options indifferent.

c).150000=A/(1+r)

=150000*1.05 = 157500

157500-150000= $7500

Initial investment should be high by $7500 so to be indifferent between investing today and waiting until next period.

answered by: anonymous