CITIC TOWER II
CITIC TOWER II: THE REAL OPTION
Suffolk University – FIN- 881
Fall 2014
Name: Abdelrhman El Refaiy
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
Suffolk University – FIN- 881
Fall 2014
Name: Abdelrhman El Refaiy
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