A firm owns the right to erect an office building on a parcel of land in downtown Sacramento over the next year. This building would cost $38 million to construct.

Due to low demand for office space in the downtown area, such a building is worth approximately $36 million today. If demand increases, the building would be worth $39.2 million a year from today. If demand decreases, the same office building would be worth only $35 million in a year. The company can borrow and lend at the risk-free annual effective rate of 6.8 percent.

A local competitor in the real estate business has offered the firm $X for the right to build an office building on the land. Use the binomial model to find the value of X that would leave the firm indifferent to accepting or rejecting the offer.

Assume risk-neutrality and round your answer to the nearest cent.

Q2. A firm specializes in manufacturing steel rods and is considering leasing the only warehouse in the area that suits the firm's operations.

The current price of steel is $734 per ton. If the price of steel falls over the next eight months, the company will purchase 625 tons of steel and produce 68,750 steel rods. Each steel rod will cost $17 to manufacture (ignore the time it takes to manufacture) and the company plans to sell the rods for $27 each.

If the price of steel rises or remains the same, it will not be profitable to undertake the project, and the company will allow the lease to expire without producing any steel rods.

Treasury bills that mature in eight months yield a continuously compounded interest rate of 5 percent and the standard deviation of the returns on steel is 45 percent.

Use the Black-Scholes Model to determine the maximum amount that the company should be willing to pay for the lease.

Round your answer to the nearestcent.

Answer rating: 100% (QA)

Q1 Binomial Model Lets break down the problem The firm has the right to erect an office building on a parcel of land in downtown Sacramento The buildi... View the full answer