Question

You own a wholesale plumbing supply store. The store currently generates revenues of $1 million per year. Next year (the year to t=1), revenues will either decrease by 10% or increase by 5%, with equal probability, and then stay at that level as long as you operate the store. Other costs run $900,000 per year. Due to an agreement with the trade union, you have to keep this store operating for at least 3 years. Starting from the end of year 3 (t=3), you can sell the store for $500,000 anytime. (i). What is the business worth today if the cost of capital is fixed at 10%? (8 marks) (ii). Name the option embedded in your business. (2 marks) 14 (iii). What is the value of the real option embedded in your business?

Answer 1

1 16-19-1 15 0 15 519 The value of the store is the maximum of the PV of all future profits and $500,000, the value of selling the store. If the revenues decrease, then future profits are zero so the store should be shut down. Hence the value in this state is $500,000. If the revenues increase, then the PV of future profits at time 1 are: (1.05–0.9) +205,709 – 0.15+45 – 51.55 million. So it is optimal to keep the store running. Putting this on a decision tree: 1.65 50% 50% 0.50 So the PV of the time 1 expected value is: -$977.273. Since this is greater than $500,000, the value of the store is $977,273 with the option to abandon.