Question

You own a wholesale plumbing supply store. The store currently generates revenues of $1 million per year. Next year (the year to t=1), revenues will either decrease by 10% or increase by 5%, with equal probability, and then stay at that level as long as you operate the store. Other costs run $900,000 per year. Due to an agreement with the trade union, you have to keep this store operating for at least 3 years. Starting from the end of year 3 (t=3), you can sell the store for $500,000 anytime.

(i). What is the business worth today if the cost of capital is fixed at 10%?
(ii). Name the option embedded in your business.
(iii). What is the value of the real option embedded in your business?

Answer 1

To determine the store's worth today, we calculate the present value of the expected net income over three years and the $500,000 option to sell, at a 10% cost of capital. The embedded real option is the ability to sell the store at the end of year three. Valuing this option involves using option pricing models adjusted for the real-world scenario.

Step-by-step explanation:

The student's question relates to business valuation and real options within the context of a wholesale plumbing supply store's future revenues and costs. The problem includes calculating the present value of the business with a cost of capital at 10%, identifying the embedded real option, and valuing this option.

Given that revenues will either decrease by 10% or increase by 5% with equal probability, we first determine the expected revenue for the next year, which will remain constant thereafter. Then, subtracting the annual costs of $900,000 from the expected revenue gives us the expected net income per year. We can calculate the present value of the expected net income for the first three years plus the additional $500,000 which the owner can get by selling the store at the end of the third year (t=3). This present value is the business's value today.

The embedded option in this scenario is the option to sell the store for $500,000 at the end of year 3. To value this real option, we can use option pricing models that consider the volatility of the revenues and the cost of capital. This might include adapting models like the Black-Scholes model to the specifics of this real-world business scenario.