Question

FedEx is negotiating to purchase an option that would allow the firm to build a warehouse in Memphis, Tennessee any time during the next year. The cost of purchasing the construction site and constructing the warehouse would be $36 million whether the warehouse is erected immediately or at the end of the year. A virtually identical warehouse owned by a competitor could be purchased today for $33.98058 million. The proposed warehouse would have an end of the year value of $50 million if economic growth reaches 3.4 percent this year, but only $20 million if economic growth slows to 0.5 percent. Assuming UDS can borrow or lend at an annualized rate of 3.0 percent, determine the maximum amount that UDS should be willing to pay for the real option

Answer 1

Price of Warehouse is $36 Million

In 1 year the price can go to $50 Million if Growth reaches 3.4 percent or $20 Million if the growth is 0.5 percent

Lets consider the senario of both happening is 50 - 50 %

Hence on an average the price of the facility will be

50%*50 + 50%*20 = $35 Million

Now financing charges will be 3% per annum. Hence the above cost should cover the financing charges also as to not make economic loss

Hence the maximum amount UDS should pay will be

$35 Million / 1.03 = $33.98058