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Case Background

 

Citic Pacific Limited was a real estate company listed in Hong Kong. Starting business from infrastructure and related assets activities, CPL then had stakes in a string of trading and property companies. In August 1995, CPL began the development of Citic Tower. Despite of the financial crisis in Hong Kong in 1999, Citic Tower turned out to be an impressive achievement in development management.

 

Larry Yung, Chairman of CPL, had the chance to acquire a piece of land near Victoria Harbour, and develop it into another Grade A office building– namely Citic Tower II. However, the rigid Net Present Value Rule showed the project had a negative NPV. In Larry’s opinion, the prospect could change as commercial realty market was so volatile that the market may be on the upturn later. So can CPL just buy the option to purchase the land, and decide whether to launch the project one year later?

 

Analysis

The buyer of a call option has the right to purchase the underlying asset at a pre-determined price on a certain day. The right to go on with a business investment opportunity called real option, as CPL had the exclusive option to buy the land, and thus the development of the office building. In this case, we used Black-Scholes Model to price the option.

 

The variables of the model are:

S = stock price (current value of the real estate project)

X= strike price (cost of the project)

T = time until expiration

R = risk-free interest rate

V= annualized volatility of stock price

 

  1. S = stock price

The project reflected a present value of around HK$1.54 billion, which was determined by the management. However, the seller had requested an equity stake of 5% in the project. So the current value of the project would be HK$1.54 billion * (1-5%) = HK$1.463 billion.

 

  1. X= strike price

In calculating the cost of the project, we assume that the construction cost was split between the two years. 50% of design, that is $22 million was conducted during the option period, thus leaving $21 million in the first construction year. It would also accrue $30 million for marketing. Then we discounted the construction cost by 12% (WACC) to Year 1, the sum of which would be the strike price.

 

 

 

Year

1

2

3

Land Purchase

1,000,000,000

 

?

Construction

 

436,280,000

436,280,000

Design

 

21,628,000

?

Leasing

?

?

30,000,000

Sum

1,000,000,000

457,908,000

466,280,000

PV at Year 1

1,000,000,000

408,846,429

371,715,561

Strike Price

1,780,561,990

?

?

 

  1. T = time until expiration

The seller showed an interest in granting an exclusively option for 12 months. So we used 1 year as time until expiration.

 

  1. R = risk-free interest rate

We used 6.27%, the 12 months bills yield in July 2000 in the calculation.

 

  1. V= annualized volatility of stock price

Based on exhibit 2-Grade A office rental and capital value indices, we got quarterly volatility of 26%. So the annualized volatility should be (1+26%)^4 -1 = 52%.

 

Using Black-Scholes option pricing model (http://www.tradingtoday.com/black-scholes) , we got option price $227.4 million. Subtracting the option period design fees of $22 million, we still have $205.4 million, which is the option price.

 

 

After considering the volatilities in real estate industry, the net present value of the project turns to be positive. Then Larry can let his management team accept this project.

 

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Case xxxxxxx align="left"> 

Citic xxxxxxx Limited was xxxxxxx xxxxxxx estate xxxxxxx listed in xxxxxxx Kong. Starting xxxxxxx from xxxxxxx xxxxxxx related assets xxxxxxx CPL then xxxxxxx stakes in xxxxxxx string of xxxxxxx and property xxxxxxx In August xxxxxxx xxxxxxx began xxxxxxx development of xxxxxxx Tower. Despite xxxxxxx the xxxxxxx xxxxxxx in Hong xxxxxxx in 1999, xxxxxxx Tower turned xxxxxxx to be xxxxxxx impressive achievement xxxxxxx development management.

 

 

X= xxxxxxx price (cost xxxxxxx the project)

R xxxxxxx risk-free interest xxxxxxx align="left">V= xxxxxxx xxxxxxx of stock xxxxxxx align="left"> 

  1. S xxxxxxx stock price

The project xxxxxxx a present xxxxxxx of around xxxxxxx xxxxxxx which xxxxxxx determined by xxxxxxx management. However, xxxxxxx seller xxxxxxx xxxxxxx an equity xxxxxxx of 5% xxxxxxx the project. xxxxxxx the current xxxxxxx of the xxxxxxx would be xxxxxxx xxxxxxx * xxxxxxx = HK$1.463 xxxxxxx align="left" style="margin-left:21.0pt;">

 

 

Year

2

3

Land xxxxxxx nowrap="nowrap" style="width:111px;height:18px;">

 

?

Construction

  436,280,000

436,280,000

Design

1,780,561,990

?

?

 

  1. T = xxxxxxx until expiration

The seller xxxxxxx an interest xxxxxxx granting an xxxxxxx xxxxxxx for xxxxxxx months. So xxxxxxx used 1 xxxxxxx as xxxxxxx xxxxxxx expiration.

R xxxxxxx risk-free interest xxxxxxx align="left" style="margin-left:21.0pt;">We xxxxxxx 6.27%, the xxxxxxx months bills xxxxxxx xxxxxxx July xxxxxxx in the xxxxxxx align="left" style="margin-left:21.0pt;"> 

  1. V= xxxxxxx xxxxxxx of stock xxxxxxx align="left" style="margin-left:21.0pt;">Based xxxxxxx exhibit 2-Grade xxxxxxx office rental xxxxxxx capital value xxxxxxx we got xxxxxxx xxxxxxx of xxxxxxx So the xxxxxxx volatility should xxxxxxx (1+26%)^4 xxxxxxx xxxxxxx 52%.

    Using xxxxxxx option pricing xxxxxxx (http://www.tradingtoday.com/black-scholes) xxxxxxx we got xxxxxxx price $227.4 xxxxxxx xxxxxxx the xxxxxxx period design xxxxxxx of $22 xxxxxxx we xxxxxxx xxxxxxx $205.4 million, xxxxxxx is the xxxxxxx price.

     

     

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