Question: ABC Construction, Inc., is currently considering developing, on a piece of land currently held by the company, a new courtyard motel. This project would provide

ABC Construction, Inc., is currently considering developing, on a piece of land currently held by the company, a new courtyard motel. This project would provide a single payoff from a buyer in one year (after construction was completed).

The concept of a courtyard motel is relatively new; so there is a certain amount of risk associated with this project. The company's management feels that new information regarding potential consumer demand would be revealed, that is, whether in the chosen geographic location a courtyard motel would be popular ("good news") or unpopular ("bad news"). You anticipate a selling price of $13 million in the former case while a selling price of only $9 million in the latter case. At present, these two outcomes are considered equally likely. For projects of this sort, the company uses a WACC (discount rate) of 10% after tax. The company estimates that the total construction costs for this project would, in today's dollars, be approximately $9.7 million.

Tasks:

Answer the following questions:

Examine the given probabilities for the two possible outcomes including the expected NPV of the proposed investment.
Compare real options with financial options.
Explain what other types of real options can be embedded in a capital investment proposal, and how these classes relate to put options and call options.

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