1. 1. Framing the Decision
2. Recreational Properties obtained a package of options to acquire three parcels that would allow them to develop a ski resort. The company paid €500,000 for the package of options in June 2001. The options gave the company the right, but not the obligation, to acquire the three parcels at a (strike) price of €10 million in June 2002. 3. Furthermore, in order to develop the three parcels into a ski resort, the company needed leases from the European Union Environment Agency. When the company purchased the options, they expected the leasing agreement before December 2001. Unfortunately, a group of conservationists had filed a lawsuit against the EU Environment Agency. Because of this suit, the Agency Commissioner refused to consider the leasing agreement for the east side of the mountain until the outcome of the lawsuit.
4. a. Objective of Recreational Properties: The main objective of Recreational Properties is to analyse the options and outcomes with respect to the package of options realistically available to them. 5. b. Decisions to be made:
c. i. Exercise the options and acquire the three parcels or not. d. ii. If the options are exercised, either sell the property without any development or develop the property at an extra cost of approximately €5 million. 6. e. Uncertainties involved in the decisions: These observations might be directly extracted from the decision tree in appendix 1. a. iii. Lawsuit outcome: The main uncertainty that Recreational Properties faces is that of the outcome of the lawsuit which translates into either getting the lease for the east side of the mountain or not. This uncertainty is estimated at 50% probability thereby reducing the expected value by €3.7 million. b. iv. Reputation: The uncertainty of the popularity of the developed ski resort contributes to different expected values in the decision tree. There is an estimated likelihood of 75% that the resort would have a good reputation. As a result of this uncertainty the expected value is reduced with an amount of €1.3 million. 2. v.
4. 7. The Emergency Meeting:
1. f. The Best Course of Action:
g. From the decision tree (see appendix 1), we can fold back the expected value. Note that we have taken into account the costs directly when they were occurring. For instance, we have a 10 million cost as soon as the options are exercised. Therefore, the expected value might be directly compared to other options. Please note also that option cost (0.5 million) is not counted in the tree. Indeed, this happened in the past and thus will not influence our decision. But it also means that if we need to calculate the real return on investment, we should remember that it is not present in our tree. h. The expected value from this tree is 1.7125 million. The decisions taken are to exercise the options and to develop the parcels. Nevertheless, this choice is the riskiest. Based on the risk profile (see appendix 2), we can clearly see that 50% of the time, the return is negative (-2 million). Thus, if the company liquidity is not high enough, this decision might have dangerous consequences. Nevertheless, we’re assuming that Recreational Properties is a sound company with a good risk appetite. 2. i. Change in Value due to Lawsuit:
* j. The previous situation might be simulated by increasing the leasing probability to 100% (see appendix 3). In that case, the expected value is simply the mean between the selling return in case of bad and good reputation. We reach a value of 5.425 million. The lawsuit is therefore responsible for a loss of 3.1725 million in the expected return on this project. But furthermore, the risk profile is different too. With a 100% probability for the lease to...