# Cittic Tower Ii Solution

Topics: Net present value, Mathematical finance, Option Pages: 6 (1882 words) Published: March 12, 2013
EXECUTIVE SUMMARY:

The company should decide whether to go ahead with the Citic Tower II project or not. The following alternatives can be used to address the problem: NPV: Net present value (NPV) is defined as the total present value (PV) of a time series of cash flows. It is a standard method for using the time value of money to appraise long-term projects. The method is used for capital budgeting, and widely throughout economics, it measures the excess or shortfall of cash flows, in present value terms, once financing charges are met.

OPTION PRICING: The buyer of a call option gets the right to buy the underlying the underlying asset at affixed price, where as the buyer of a put option obtains the right to sell the underlying asset at a fixed price. Alternatives to the binomial model In the binomial option pricing model, the underlying asset and risk free lending or borrowing are combined to create a portfolio that had the same cash flows as the option being valued; we called this portfolio the replicating portfolio. Although the binomial model provides the intuitive feel for the determinants of the option value, it requires a large number of inputs in terms of expected future prices at each node. As we can make time periods shorter in the binomial model, we can make assumptions about asset prices. We can assume that price changes becomes smaller as time periods approaches zero leading to continuous price process. THE BLACK – SCHOLES MODEL: When the price process is continuous, that is price changes become smaller as time period gets shorter, the binomial model for pricing options converges on the Black – Scholes model. The model allows us to estimate the value of any option using a small number of inputs, and it has shown to be remarkably robust in valuing many listed options. The Black-Scholes model is used to calculate a theoretical call price (ignoring dividends paid during the life of the option) using the five key determinants of an option's price: stock price, strike price, volatility, time to expiration, and short-term (risk free) interest rate. The original formula for calculating the theoretical option price (OP) is as follows:

Where:

The variables are: S=stock price X=strike price

t = time remaining until expiration, expressed as a percent of a year r = current continuously compounded risk-free interest rate v = annual volatility of stock price (the standard deviation of the short-term returns over one year). See below for how to estimate volatility. ln = natural logarithm N(x) = standard normal cumulative distribution function e = the exponential function

VOLATILITY: Volatility refers to the amount of uncertainty or risk about the size of changes in a security's value. A higher volatility means that a security's value can potentially be spread out over a larger range of values. This means that the price of the security can change dramatically over a short time period in either direction. A lower volatility means that a security's value does not fluctuate dramatically, but changes in value at a steady pace over a period of time.

CASE BACKGROUND

Citic Pacific Limited was a real estate company incorporated in Hong Kong. The CPL’s activities include civil facilities such as complex bridge, road and tunnel facilities to power generation, environmental projects, aviation and telecommunications. The development of Citic tower represented an impressive achievement in development management. In 1999, despite the property market being affected by the post-Asian financial crisis, weak demand and falling prices, Citic tower still maintained a relatively high occupancy rate. Given the cyclical nature of the market, CPL’s property revenues were significantly less predictable than the revenues from the company’s infrastructure assets. Property investment projects were generally based on 12 percent required return on investment based on CLP’s weighted average cost of capital. The present issue that...