Question

Problem 15-15 A real estate investor has the opportunity to purchase land currently zoned as residential. If the county board approves a request to rezone the property as commercial within the next year, the investor will be able to lease the land to a large discount firm that wants to open a new store on the property. However, if the zoning change is not approved, the investor will have to sell the property at a loss. Profits (in thousands of dollars) are shown in the following payoff table: State of Nature Rezoning Approved Rezoning Not Approved Decision Alternative s1 s2 Purchase, d1 550 -250 Do not purchase, d2 0 0 (a) If the probability that the rezoning will be approved is 0.5, what decision is recommended? Recommended Decision: What is the expected profit? $ (b) The investor can purchase an option to buy the land. Under the option, the investor maintains the rights to purchase the land anytime during the next three months while learning more about possible resistance to the rezoning proposal from area residents. Probabilities are as follows: Let H = High resistance to rezoning L = Low resistance to rezoning P(H) = 0.55 P(s1 | H) = 0.16 P(s2 | H) = 0.84 P(L) = 0.45 P(s1 | L) = 0.85 P(s2 | L) = 0.15 What is the optimal decision strategy if the investor uses the option period to learn more about the resistance from area residents before making the purchase decision? High resistance: Low resistance: (c) If the option will cost the investor an additional $10,000, should the investor purchase the option? Why or why not? The input in the box below will not be graded, but may be reviewed and considered by your instructor. blank What is the maximum that the investor should be willing to pay for the option? EVSI = $

Answer 1

ANSWER:-

Expected profits = ( 550 x 0.5 ) + (- 250 x 0.5 ) = $150,000

Expected Profits / Loss in high resistance = ( 550 x 0.16 ) + ( - 250 x 0.84 ) = -$122,000 x 0.55 = -$67,100

Profits / Loss in low resistance = (550 x 0.86) + (-250 x 0.14) = $438,000 x 0.45 = $197,100

Optimal decision during high resistance is do not purchase and during low resistance purchase.

The maximum the investor should be willing to pay for the option = $197,100 - $150,000 = $47,100\

If the option is available at $10000 the investor should purchase the option as it is available at a lower value

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