Real options Nevada Enterprises is considering buying a vacant lot that sells fo

Question

Real options

Nevada Enterprises is considering buying a vacant lot that sells for $1.9 million. If the property is purchased, the company's plan is to spend another $6 million today(t = 0) to build a hotel on the property. The cash flows from the hotel will depend critically on whether the state imposes a tourism tax in this year's legislative session. If the tax is imposed, the hotel is expected to produce cash inflows of $600,000 at the end of each of the next 15 years. If the tax is not imposed, the hotel is expected to produce cash inflows of $1,800,000 at the end of each of the next 15 years. The project has a 14% WACC. Assume at the outset that the company does not have the option to delay the project.

Write out your answers for parts a, b, c and e completely. For example, 13 million should be entered as 13,000,000.

a. What is the project's expected NPV if the tax is imposed? Round your answer to two decimal places. If the answer is negative, use minus sign.
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b. What is the project's expected NPV if the tax is not imposed? Round your answer to two decimal places. If the answer is negative, use minus sign.
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c. Given that there is a 50% chance that the tax will be imposed, what is the project's expected NPV if management proceeds with it today? Round your answer to two decimal places. If the answer is negative, use minus sign.
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d. While the company does not have an option to delay construction, it does have the option to abandon the project 1 year from now if the tax is imposed. If it abandons the project, it would sell the complete property 1 year from now at an expected price of $6 million after taxes. Once the project is abandoned the company would no longer receive any cash flows. Assuming that all cash flows are discounted at 14%, will the existence of this abandonment option affect the company's decision to proceed with the project today?
-Select-yesnoItem 4

   Explain.

e. Finally, assume that there is no option to abandon or delay the project, but that the company has an option to purchase an adjacent property in 1 year at a price of $1.5 million (outflow at t = 1). If the tourism tax is imposed, the net present value of developing this property (as of t = 1) will be only $300,000 (so it doesn't make sense to purchase the property for $1.5 million). However, if the tax is not imposed, the expected net present value of the future opportunities from developing the property will be $4 million (as of t = 1). Thus, under this scenario it makes sense to purchase the property for $1.5 million (at t = 1). Assume that these cash flows are discounted at 14%, and the probability that the tax will be imposed is still 50%. What is the most the company would pay today (t = 0) for the $1.5 million purchase option (at t = 1) for the adjacent property? Round your answer to two decimal places.
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Explanation / Answer

a. Calculation of Project's expected NPV if the tax is imposed: Particulars Amount Present Value Factor Present Value Cash outflows: Vacant Lot $ 1,900,000.00 1 $     1,900,000.00 Property $ 6,000,000.00 1 $     6,000,000.00 $     7,900,000.00 Cash Inflows: Annual Cash Infow: $     600,000.00 6.142167985 $     3,685,300.79 Net Present Value $   -4,214,699.21 b. Calculation of Project's expected NPV if the tax is not imposed: Particulars Amount Present Value Factor @ 14% Present Value Cash outflows: Vacant Lot $ 1,900,000.00 1 $     1,900,000.00 Property $ 6,000,000.00 1 $     6,000,000.00 $     7,900,000.00 Cash Inflows: Annual Cash Inflow $ 1,800,000.00 6.142167985 $   11,055,902.37 Net Present Value $     3,155,902.37 c. Calculation of Project's expected NPV if there is a 50% chance that tax is imposed: If there will be 50% chance of imposition of tax then there will also be 50% chance that the tax will not be imposed. For the purpose of calculation of the Net Present Value, we should take Cash Inflows as a product with probability Amount Probability Cash Inflows Cash Inflow (With Tax) $     600,000.00 50% $         300,000.00 Cash Inflow (Without Tax) $ 1,800,000.00 50% $         900,000.00 Sum $     1,200,000.00 Hence as per given probabilities, $12,00,000 should be considered as Cash Inflows for calculation of the NPV. Calculation of the NPV Particulars Amount Present Value Factor @ 12% Present Value Cash outflows: Vacant Lot $ 1,900,000.00 1 $     1,900,000.00 Property $ 6,000,000.00 1 $     6,000,000.00 $     7,900,000.00 Cash Inflows: Annual Cash Inflow $ 1,200,000.00 6.142167985 $     7,370,601.58 Net Present Value $       -529,398.42 d. Calculation of NPV if there is an abandoned Option (if the tax is imposed) Particulars Amount Present Value Factor @ 14% Present Value Cash outflows: Vacant Lot $ 1,900,000.00 1 $     1,900,000.00 Property $ 6,000,000.00 1 $     6,000,000.00 $     7,900,000.00 Cash Inflows: Annual Cash Inflow $ 6,000,000.00 0.877192982 $     5,263,157.89 Net Present Value $   -2,636,842.11 Conclusion: Even if the project is abandoned after one year, if the Tax is imposed, the Negative NPV would be lesser than Negative NPV if the project is carried when tax is imposed. Therefore YES, the option to abandon will affect the decision of the company. If the abondonement option is considered the Negative NPV in the abandonement option is lesser than if the project is continued with tax imposition. It is advisable that if the tax is imposed, the company should abandone the project instead of carrying it on for 15 years e. Calculation of maximum payable price for adjacent property at t=0 Maximum Payble price at t=1 $ 1,500,000.00 Present value factor @14% 0.877192982 Maximum payable at t=0 $ 1,315,789.47

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