An Investor Group Has the Opportunity to Purchase a Firm

Essay

An investor group has the opportunity to purchase a firm whose primary asset is ownership of the exclusive rights to develop a parcel of undeveloped land sometime during the next 5 years. Without considering the value of the option to develop the property, the investor group believes the net present value of the firm is $(10) million. However, to convert the property to commercial use (i.e., exercise the option), the investors will have to invest $60 million immediately in infrastructure improvements. The primary uncertainty associated with the property is how rapidly the surrounding area will grow. Based on their experience with similar properties, the investors estimated that the variance of the projected cash flows is 5% of the NPV, which is $55 million, of developing the property. Assume the risk-free rate of return is 4 percent. What is the value of the call option the investor group would obtain by buying the firm? Is it sufficient to justify the acquisition of the firm?