Reference no: EM133110274

Problem 1: Suppose you have just inherited 10 acres of land from your long-lost uncle. The acreage is currently undeveloped and unused, but after some research, you discover that it might be a great site for a pecan orchard at some point in the future. You think it will cost $0.5M to plant the trees, install an irrigation system, and purchase the required maintenance and harvesting equipment, and estimate that pecan orchards typically have a 5% cash flow yield. Unfortunately, based on the forecasted pecan prices, you have estimated that the discounted expected value of the orchard would currently only be $0.4M. Due to weather and other factors, however, there is a significant amount of uncertainty in the pecan price forecast and the actual value of the orchard in the future. You estimate that the volatility of the value of the orchard is 20%. The current risk free rate is 5%.

a) Given that the orchard project is not a good investment at the current time, you decide to look into selling the property. However, you want to include the value of the option to plant an orchard in the value of the land. What is that value? Show your calculations in your worksheet.

b) If you don't receive an acceptable offer for the land and end up keeping it, when would you go ahead with the orchard project?