Question

Real Option Homework

CaliLand is an old fashioned amusement park based in Neverland, California. Jack Michaelson, the founder and CEO of Cali Land, is retiring and wants to sell the park.

Michaelson is offering the park for sale. Thriller Land’s primary asset is the huge tract of land in the Southern California, which even if the park were closed would be worth $50,000,000. The park is on target to producing an annual cash flow of $5,000,000 in the coming year. Michaelson has estimated the firm’s value as a going enterprise using the discounted cash flow (DCF) method. The DCF method forecasts future cash flows to the equity holders and discounts them to form a risk adjusted present value. Since the firm’s cash flow can be well modeled as growth perpetuity, the DCF method can be viewed in this case as estimating next year’s cash flow, estimating a long term growth rate and an appropriate discount rate and plugging them into the constant growth in perpetuity model:

Value = Next Annual Cash Flow / (Discount Rate – Growth Rate)

There is consensus that a discount rate of 15% is appropriate. The huge issue is revenue growth. It seems clear that if no competitors move into the area, the firm can continue to grow in the area of 10% per year into the future. However, if zoning laws are changed and competition moves in, the firm’s long term growth rate would be 0%. Experts agree that there is a 50-50 chance that the zooming laws will be changed and therefore the firm’s expected revenue growth rate is 5%.

Using these figures, the discounted cash flows method generates the following estimates:

DCF = $5 Million / (0.15 – 0.05) = $50 Million

Thus, as would be expected in efficient markets, the value of the amusement park based on its assets (in effect, its land) is equal to the value of the amusement park as a going concern (using DCF method). Do you agree?

Answer 1

1. Basis the information provided in question the amusement park can fetch value only for its land and the value of the park is derived by considering land value which is $ 50 millions.

2. There is a 50% probability of growth rate to be 10% . Hence risk adjusted growth rate is 5%.

3. The appropriate discount rate is 15% for deriving the value of amusement park

4. when the cash flows are constant for an indefinite period of time, the present value of all cash flows should be calculated as explained in question.

5. Hence the Discounted cash flow is $ 50 millions for the park.

6, It is concluded that the realization value of park and discounted cash flows fetches same figure that is $ 50 million