Reference no: EM132410917

You have a concession stand in Madison Square Garden selling fast food. You are undecided as to whether to continue running the stand or lease to a local business interested in your business. You can close your stand now and lease the stand or continue to run the concession stand for an additional year and decide to keep running it or lease it at the point. The opportunity to lease the concession stand ends next year when you have to sign a new agreement to operate it for an additional 10 years.

a. If the concession stand is run for another year the free cash flow is $0.5 million

b. If it is continued for an additional 10 years, the present value of free cash flows in year 1 (PV₁) is $3 million.

c. If operation of the concession stand is discontinued at end of 1 year and the space leased to a local company to operate the concession stand, the present value of the 10 year lease, in year 1 (PV₁) is $3 million.

d. The estimated free cash flows of the concession stand for next year could be 25% higher. The hurdle return is 10% and the risk free rate is 4%.

e. If the operation of the concession stand is discontinued immediately and the space leased to a local company to operate the concession stand, the present value of a 11 year lease now (PV₀) is $3.25. Draw the decision tree for the problem with labels.

1. How much is the present value of operating the concession stand for 11 more years?

2. The decision to abandon operation of concession stand and collect lease payments is what kind of option?  

3. How much is the present value of operating the concession stand for 11 more years with the option to abandon operating and collect the lease payments in year 1?

Hint the lease value in year 1 is the abandonment value which is option strike price.

Put Option

Market price (S)

Strike price (K)

Time in years

Percent Up

Interest rate

Option Price

4. What is your recommendation and why?