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Citic Tower II: The Real Option Essay Sample

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Citic Tower II: The Real Option Essay Sample

Larry Young the Chairman of Citic Pacific Limited has to make a decision to develop a new project under the name Citic Tower II. The development project that will take place in Hong Kong is expected to leave the company with $60 MM in losses as per NPV analysis. Citic’s property development team has set rigid assumptions to build their NPV model that estimated net positive cash inflows at $1.54 billion and total costs of ≈$1.6 billion including land that worth $1 billion. The NPV model underlying assumptions didn’t fully capture the upward potential of the gains that might be acquired from developing the project if the economic environment was to improve. However, the downside risk is currently viable as per the NPV is the negative zone.

Therefore, the ultimate payoff pattern to CPL is to engage in an option that will allow the company to improve its understanding of the potential losses or profits and it will enable the company to capture upside potential profits and tame its losses to the value of the option. The mentioned option has the same payoff of a European Call Option as shown in the above diagram. The option is to defer the decision to start developing by one year. The actual option from the seller point of view is to sell the land in 1 year to CPL for the same value. The seller valued the option as 5% of the project value. CPL’s valuation of the option will determine either to take the option or not. The seller priced the option to purchase the land at:

5% * $1,600,000,000 = $ 80,000,000
CPL Option Pricing:
CPL decision to buy the option will depend on calculating the theoretical price of the option and compare it to the actual price of the option offered by the seller. As mentioned earlier, the payoff pattern of the proposed option resembles the payoff of long European Call option from CPL’s point. Therefore, CPL should use Black-Scholes option pricing model to reach a theoretical price to determine the economic feasibility of the option. Black-Scholes model for long call option is: The valuation in accordance to the equation above consists of the following variables: C = call price

S = asset price $ 1,540,000,000
K = strike price $ 1,600,000,000
r = risk free financing rate as of December 2000 5.38%
T = time of the option 1 Year
Sigma = volatility of the asset (using the grade A office price index for the previous 15 years) 10.77% quarterly and 21.55% annualized. The call price for CPL is equal to $143,351,120 given the above mentioned assumptions. CPL decision and conclusion:

The current option offered by the seller is $80 MM and additional 50% professional design and preparatory work that will be done during the option life; the additional cost is estimated to be $22 MM and should top the original amount of the option cost. The total option cost is $102 MM compared to theoretical option price of $143 MM with a difference of $41 MM. The theoretical option price is not 100% accurate as the development costs are assumed to take place at the end of year 2 and year 3 which is not the real case scenario as they are supposed to be in S-Curve shaped payment. This effect decreased the actual price of the option and also increased the theoretical price. Therefore, CPL should negotiate with the seller to decrease its option price to 4% instead of 5% but still execute the option.

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