Recreational Properties Case
Recreational Properties 1. Framing the Decision Our objective is to maximise Anders Forsgen’s financial return from this developmental deal while keeping into account the fact that we have other option beyond this deal. We have two primary decisions to make viz. whether: a)we should exercise our option to buy The White Mountain Development, and, b)If we should develop White Mountain further to aim for higher returns The development of White Mountain is attractive because as it only involves incremental capital costs, and no loss in time in terms of selling the development.
These two decisions and the net pay off would be influenced by two key uncertainties viz. whether a)we would get the lease or not (now in question due to the lawsuit), and, b)after development if we would be able to generate enough popularity for the resort to reap additional returns. In case the decision on the lease is not favourable, we are better off going for our alternative safe option with a net pay off of +1. 5M. A favourable lease decision lends us returns of +1. 7M on average, through exercising our option of buying White Mountain Development.
The reputation of the resort will affect our payoffs in case we get a favourable result on the lease (or at least expect to), and development of the resort gives us an incremental +5. 5M over simply selling it without development. 2. The emergency meeting The best course of action, given the current options and uncertainty estimates, is to exercise the option as the average expected value is 1. 7M vs. 1. 5M for not exercising it. (Figure 1) Prior to the lawsuit our expected value was 5. 4M (Figure 2) whereas it is now 1. M. Consequently the lawsuit has dropped our expected value by 3. 7M. Therefore if we we’re sure that our Environmental report would secure the lease we should be willing to spend up to $3. 7M for this report. 3. Sensitivity analysis Changes in the estimated probabilities for our uncertainties impact the total average value of our decision options. In general the higher the probability of the lease being granted and the higher the probability that we develop a good reputation the more return we can get.
Attached is the detailed chart showing the interplay between these two probabilities (Figure 3). It also shows two nuanced inputs i. e. a)That for almost all cases below 50% probability of lease being granted we are better of not exercising the option to buy the development, and, b)That given that we have a favourable lease decision, we are better off on average developing the resort, but in the absence of a certainty on lease decision, its unclear whether we should exercise out option or not in the first place.
As our payoff estimates are changing favourability of options too close to the base case scenario, we cannot make sound recommendations at this time. A slight change in the probability of the lease being granted or our ability to develop or good reputation reverses our optimal decision. Consequently we should have less confidence in our recommendation and attempt to gain more information or time. It is to be noted that solely getting a higher certainty on the lease decision may help us provide a clear recommendation, as this uncertainty is pivotal in our choice of decision.
Sensitivity Table 4. Extending the Option The key reason for Dolores to consider this as a good option is that it eliminates the uncertainty of the ruling on the lease issue. Consequently the average realizable value jumps up from 1. 7M to 3. 5M, a gain of $1. 75M (Figure 4), which is the maximum value Anders should be willing to pay for the one-year extension. The existence of the lawsuit eliminated $3. 7M of our average realizable value The extension of the option would drop it by 5. 43 – 3. 46 = $1. 96M only. In other words it would have helped us recover 1. 6M of the valuation drop due to the lawsuit. However the fact that the lawsuit was brought to the courts is more significant than our ability to extend our option. 5. Meeting the landowners The six-month extension increases our average payoff from 1. 71 to 2. 72, which is an increase of 1. 01 million. This increase is due to the reduction (not the elimination) of the uncertainty of being granted the lease. After the court decision we can be much more certain about the possibility of the outcome of the hearings. The price of the one-year extension was 1. 75 Vs. 1. 01 for the six month one.
This is being driven by the fact that a one year extension completely eliminated our uncertainty of being granted the lease while the six month one only reduced it. 6. The Final Negotiation As we understand it, Anders’ two options are a)no extension whatsoever (Avg Value 1. 71) vs. b)six month extension (Avg Value 2. 07) If the probability of a favourable court ruling were less than 11% then we should NOT buy the option and if the probability of a favourable court ruling more than 56% we should again NOT buy the option. The sweet spot essentially between these two probabilities.