Decision-making by Judo strategy

The seller (S) and buyer (B)

The seller (S) wants to sell the asset for $2 mil, but currently has an offer for only $1 mil (50% of the asking price). The buyer (B) might be right to assume that the seller (S) wants to liquidate the asset to meet another business need. The buyer (B) assumes that the seller (S) needs the cash to make a purchase. It's possible that the seller (S) wants to liquidate the asset (convert it to cash) so that s/he can invest in another asset that provides a greater rate of return....greater than any appreciation s/he could hope to see with the current asset in question.

The buyer (B) wants the asset but is unwilling to pay $2 mil. S/he is offering quite a low offer - 50% less than the asking price, but needs to make the deal unique. S/he is afraid that the seller (S) will simply walk away from the deal, so s/he sweetens it by offering an option to repurchase the asset one year later (t = 1). The buyer (B) is correct in assuming that if the true value of the asset is closer to $2 mil than $1 mil, the seller (S) will repurchase the asset at t = 1 and try to sell it again for $2 mil to someone else.

The question for both B and S: what should the option price be to make this deal profitable?

The seller's (S) perspective

For the seller (S), the option price will factor into what s/he earns from the sale of the asset at t = 0. If S sells the asset for $1 mil, the net proceeds s/he receives will be less the option price.

@ t = 0, Proceeds_S = $1 mil - Price_option

What S does with those proceeds between t = 0 and t = 1 will determine if s/he should accept the option at a certain price. Let's assume S will liquidate the asset to invest the cash in something that provides a greater rate of return than the asset itself. Since most assets *depreciate* over time, S is sure to find something in the marketplace that will *appreciate* his/her investment (= $1 mil - Price_option). 

Thus, we need to compound the investment S makes at t = 0 for one period (to t = 1) because s/he has only 1 year to appreciate the investment. At t = 1, the investment must grow to more than the buyer's asking price of $1.1 mil. 

The seller's (S) efficient frontier

The seller (S) is unaware of the option price, but knows that the price that s/he is willing to pay will be dictated by the rate of return that s/he can earn on the t = 0 investment of $1 mil - Price_option. With two unknown variables (rate of return and Price_option), s/he creates an efficient frontier. 

The buyer's (B) perspective

On the other hand, the buyer (B) has a different perspective. Presumably s/he wants the asset so s/he can use it in the operations of his/her business. However, given that s/he is offering an option for the seller (S) to repurchase the asset, there is a chance that B only wants the asset for a quick return on investment. How quick? Since B is purchasing it for $1 mil at t = 0 and ready to resell it for $1.1 mil at t = 1, the investment will return about 10% in one year (excluding the option price for simplicity). If the buyer (B) really needs the asset for business operations, then it would be unwise for him/her to offer a repurchase option in one year, especially considering the asset won't reach an equilibrium in the free cash it generates within that first year of use.

What should the seller (S) do?

The seller knows a few things about the buyer (B) based on the offer:

1. the buyer (B) is willing to part with the asset after one year, suggesting that it (the asset) may not be so critical to the success of his/her business operations

2. the buyer (B) isn't able to find a return on his/her $1 mil investment greater than 10%. If s/he did have an alternative investment that returned > 10%, the repurchase price that the buyer (B) quoted would have been more than $1.1 mil

   1. since the buyer (B) is signaling that s/he can't find an alternative investment that returns > 10% in one year, there's a good chance that the seller (S) won't be able to find one either

   2. according to the efficient frontier, the seller (S) needs an alternative investment whose return is > 10% in year 1 to earn a profit after paying for the option.

The seller (S) has some alternative deals with which to counter:

1. accept an options price that is at-or-lower than the value in the efficient frontier based on the rate of return of an alternative investment instrument that s/he can find

   1. and then, plan on executing on the option at t = 1 (i.e., plan on repurchasing the asset)

2. reject the option outright if there isn't an alternative investment that returns > 10% in one year

3. call the buyer's (B) bluff and offer to lease the asset - the seller (S) keeps the asset and continues his/her search for a new buyer willing to spend $2 mil (the original asking price) 

   1. this offer checks the buyer's (B) true intentions for the asset: does s/he want to use the asset for 

a) his/her operations or 

b) a quick 10% investment opportunity

This exposition explains how I would use the Judo strategy to evaluate the surprise term (option) in this deal. How do you see it? Message me below to start a conversation.