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Citic Pacific Limited is a real estate company incorporated in Hong Kong. The CPLs activities include civil facilities such as complex bridge, road and tunnel facilities to power generation, environmental projects, aviation and telecommunications. The development of Citic tower represented an impressive achievement in development management. In 1999, despite the property market being affected by the post-Asian financial crisis, weak demand and falling prices, Citic tower still maintained a relatively high occupancy rate. Given the cyclical nature of the market, CPLs property revenues were significantly less predictable than the revenues from the companys infrastructure assets. Property investment projects were generally based on 12 percent required return on investment based on CLPs weighted average cost of capital. The present issue that Larry Yung, Chairman of Citic Pacific Limited is facing is regarding the impressive Victoria harbor and an undeveloped prime waterfront site, which he planned to call as Citic Tower II. Larry thought CPL could acquire the site and develop it into another grade A office building in central. The asking price of the land was HK $1 Billion, and the estimated scale of the building and development costs were comparable to those of Citic tower. Through a feasibility report, Larry found to his disappointment that investing in Citic tower II did not seem to bring about clear positive returns. Under the rigid assumptions set by property development team and the deal reflected a present value of around HK $1.54 billion and a cost of around HK $1.6 Billion. Larry intuitively felt that the decision did not allow for any flexibility, managerial discretion or strategic actions. Hence there was a need to do a more exhaustive analysis taking all the factors into consideration and taking into account different types of models such as the Black Scholes model. The option to purchase the land would allow CPL to defer the decision to develop for one year. It also involves some risks. If the project was truly a winner, waiting would mean a loss or deferral of its early cash flows. However, since the project did not appear to be clearly attractive



Dinesh J. Vatani

at this point, waiting could prevent a big mistake. CPL was hoping that the seller would grant CPL an option to defer purchase on the land, exercisable at the end of one year, thereby allowing CPL to defer the whole project for one year. With the talks, the seller had shown an interest in granting an exclusive option for 12 months. However, as the price of the option, it had requested an equity stake of 5% in the completed project. The decision in front of Larry and CPL was whether they should accept the sellers proposed terms and get the exclusivity option which offered additional choices, but at the same time was difficult to assess. ANALYSIS: BLACK SCHOLES MODEL

The analysis is done with the help of Black-Scholes model which is generally used for calculating the value of options. This model allows us to estimate the value of any option using a small number of inputs, and it has shown to be remarkably robust in valuing many listed options. The Black-Scholes model is used to calculate a theoretical call price (ignoring dividends paid during the life of the option) using the five key determinants of an option's price: stock price, strike price, volatility, time to expiration, and short-term (risk free) interest rate. The original formula for calculating the theoretical option price (OP) is as follows:


The variables are: S = stock price X = strike price t = time remaining until expiration, expressed as a percent of a year r = current continuously compounded risk-free interest rate v = annual volatility of stock price (the standard deviation of the short-term returns over one year). See below for how to estimate volatility. ln = natural logarithm

N(x) = standard normal cumulative distribution function e = the exponential function

VOLATILITY: Volatility refers to the amount of uncertainty or risk about the size of changes in a security's value. A higher volatility means that a security's value can potentially be spread out over a larger range of values. This means that the price of the security can change dramatically over a short time period in either direction. A lower volatility means that a security's value does not fluctuate dramatically, but changes in value at a steady pace over a period of time. Let us first determine each input required for applying the Black-Scholes model for the current model. # 1 Var Value of the current asset Description It is determined by the management team that the project reflected a present value of HK $1.54 billion. Hence we can take this as the current estimated value of the project. Also, it is given that the seller requested 5% equity stake in the completed project. Hence 5% of the $1.54 billion has to be deduced from the value to get the actual value of the project. = HK $1.463 billion = 95% of HK $1.54 billion Value Value of the project

Time to expiration of the option

Since Larry is expecting the market to recover in the next year, we take t = 1 year.

t = 1 year

Strike price

Strike price is the total investment that is required to be made in the project. The investment spans across a period of three years. Hence, when determining the strike price of the project, the appropriate value can be obtained by calculating the present value of all the investments to be made for the project.

X = PV of $1.79 billion

= $1.6 billion

Riskless rate

Generally the risk free rate to be considered should correspond to the riskless rate which has a period

r = 6.27%

corresponding to the duration of the option itself, which is one year. Hence, we have to take the riskless rate corresponding to the month of July 2000 and for the 12 month bills

Calculating d1 and d2:

 = 0.10295 = 0.541  = -0.24967 = 0.401

Substituting the values in to the Black Scholes model:

 OP = 1.463 billion * (0.541) 1.6 billion * (e)-(6.27)*(1) *(0.401) OP = HK $188,892,280

Hence, considering the volatility the industry, the net value from the project is positive and significant. This value means that the management has taken a good decision by taking the option of considering the investment in the project.


The Citic pacific Limited (CPL) deals with the real estate market which is highly volatile. Discount Cash Flow method (DCF) which is the most common method used in evaluating real estate projects, fails when there is uncertainty (volatility) involved in the future cash flows or if there is huge fluctuation in the discount rates used. Hence, when volatility is involved, BlackScholes model can be used to evaluate the investment decisions. The current investment decision to invest in the Citic Tower II project was evaluated using the Black-Scholes model and we get a positive value of HK $188.9 million. The recommendation for the Citic Pacific Limited would be to go ahead with the project.