Reference no: EM132209095

Question - You are considering the purchase of a vacant lot, upon which you will build an apartment building. The price of the lot is $100,000 and you have obtained a commitment from a local builder, good for one year, to construct an apartment on the lot for $400,000 in construction costs. There are two possible states of the world, each occurring with equal probability. In the good state, demand for housing will be high and the perpetual after-tax cash flow (after all operating and maintenance expenses) generated by the apartment will be $100,000/year. In the bad state, demand will be low and the perpetual cash flow will be only $50,000/year. The level of demand is the same in all years (demand is revealed at the end of the first year). Use a discount rate of 10% in all calculations. Assume that revenues begin one year after construction costs are incurred. Further assume that the value of the lot in its next-best use (i.e. without an apartment building on it) is $50,000.

A) Suppose that in order to obtain financing to buy the vacant lot, you must construct the apartment building immediately. What is the NPV of the project?

B) Suppose that the financing constraint described in part A does not exist. Further suppose that, since you are not the only interested buyer, the seller has decided to auction the vacant lot. What is the maximum amount you would bid? Give an intuition for your answer.

C) Suppose that instead of $100,000 or $50,000, after-tax cash flows are either $150,000 (in the good state) or $0 (in the bad state), again with equal probability. Expected cash flows are still $75,000. Would you bid a lower or higher amount for the land? Assume that all other revenues and costs are the same. Please provide an intuitive answer.