Question

KF can obtain an option on a site for $100,000 on 31 Dec 2012. The option would give KF the right to purchase the site for $2.6million on 31 Dec 2017. It is estimated that similar sites will then have a market value of $3 million. Calculate the present value of purchasing the option now and compare it with the present value of purchasing the land outright later on. Which is the better alternative? Why?

Answer 1

Question#8835

KF can obtain an option on a site for $100,000 on 31 Dec 2012. The option would give KF the right to purchase the site for $2.6 million on 31 Dec 2017. It is estimated that similar sites will then have a market value of $3 million. Calculate the present value of purchasing the option now and compare it with the present value of purchasing the land outright later on. Which is the better alternative? Why

Answer:

1) $PV_{1} = \frac{2.6}{(1 + i)^{5}}$

2) $PV_{2} = \frac{3}{(1 + i)^{5}}$

3) If $PV_{1} + \$100,000 < PV_{2}$ then better alternative is to buy option

If $PV_{1} + \$100,000 > PV_{2}$ then better alternative is to purchase the site in 2017 without option

Present value depends on interest rate, which is used in the market