An Investor Group Has the Opportunity to Purchase a Firm

question 19

Essay

An investor group has the opportunity to purchase a firm whose primary asset is ownership of the exclusive rights to develop a parcel of undeveloped land sometime during the next 5 years. Without considering the value of the option to develop the property, the investor group believes the net present value of the firm is $(10) million. However, to convert the property to commercial use (i.e., exercise the option), the investors will have to invest $60 million immediately in infrastructure improvements. The primary uncertainty associated with the property is how rapidly the surrounding area will grow. Based on their experience with similar properties, the investors estimated that the variance of the projected cash flows is 5% of the NPV, which is $55 million, of developing the property. Assume the risk-free rate of return is 4 percent. What is the value of the call option the investor group would obtain by buying the firm? Is it sufficient to justify the acquisition of the firm?

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Definitions:

Ear

The organ of hearing and balance in humans and other vertebrates.

Cerumen Impaction

A blockage of the ear canal with earwax (cerumen), which can cause pain and hearing loss.

Immobilization

The act of restricting movement to prevent further injury or to assist in the healing process of bones, joints, or muscles.

Stapes

A small, stirrup-shaped bone in the middle ear that plays a key role in transmitting sound vibrations to the inner ear.