Reference no: EM132042792

My friend owns a small old house that is worth approximately $1.1 million. Given the improved real estate market, my friend is considering that over the next three years, she would have the option of tearing down this small old house and build a more expensive house. Her research suggests that the current cost of tearing down the old house and building a new more expensive will be approximately $800,000 and that she should assume that the expected cost would increase by 3%/year in the future. The current value of a comparable house to the one she is thinking of building is approximately $1.8 million. Finally, she believes that the standard deviation of the annual changes in homes prices in this price range is approximately 50%/year. Ignoring flexibility, what is the current expected NPV of the investment to tear down the old house and build the more expensive home (assume the cost of construction occur at time 0)? What is the value of the option to tear down the original house and build a new one anytime over the next three years? (Apply a two-period per year binomial model.)