Kim Hotels is interested in developing a new hotel in Seoul. The company estimat

Question

Kim Hotels is interested in developing a new hotel in Seoul. The company estimates that the hotel would require an initial investment of $20 million. Kim expects the hotel will produce positive cash flows of $3 million a year at the end of each of the net 20 years. the projects capital of capital is 13%.

A.) What is the project net present value?

B.) Kim expects the cash flows to be $3 million a year, but it recognizes that the cash flows could actually be much higher or lower, depending on whether the Korean government imposes a large hotel tax. One year from now, Kim will know whether the tax will be imposed. There is a 50% chance that the tax will be imposed, in which case the yearly cash flows will be only $2.2 million. At the same time, there is a 50% chance that the tax will not be imposed, in which case the yearly cash flows will be $3.8 million. Kim is deciding whether to proceed with the hotel today or to wait a year to find out whether the tax will be imposed. If Kim waits a year, the initial investment will remain at $20 million. Assume that all cash flows are discounted at 13%. Use a decision-tree analysis to determine whether Kim should proceed with the project today or wait a year before deciding.

C.) Rework the above using the Black-Scholes model to estimate the value of the option. Assume that the variance of the project's rate of return is 6.87% and that the risk-free rate is 8%.

Explanation / Answer

Kim Hotels is interested in developing a new hotel in Seoul. The company estimates that the hotel would require an initial investment of $20 million. Kim expects that the hotel will produce positive cash flows of $3 million a year at the end of each of the next 20 years.

The project's cost of capital is 13%. a. What the is project's NPV? CFO = -20M, CO1 = 3, FO1 = 20, I = 13, NPV = $1.074M

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b. While Kim expects the cash flows to be $3 million a year, it recognizes that the cash flows could, in fact, be much higher or lower, depending on whether or not the Korean government imposes a large hotel tax. One year from now, Kim will know whether the tax will be imposed.

There is a 50% chance that the tax will be imposed, in which case the yearly cash flows will be only $2.2 million. At the same time, there is a 50% chance that the tax will not be imposed, in which case the yearly cash flows will be $3.8 million.

Kim is deciding whether to proceed with the hotel today or to wait 1 year to find out whether the tax will be imposed

. If Kim waits a year, the initial investment will remain at $20 million. Assume that all cash flows are discounted at 13%. Using decision tree analysis, should Kim proceed with the project today or should it wait a year before deciding?

NPV1 no tax = CFO = -20,

CO1 = 3.8M,

FO1 = 20, I =13

NPV = $6.694

NPV1 with tax = CFO = -20, CO1 = 2.2M, FO1 = 20, I = 13, NPV = -$4.546

NOW, all would agree that if waiting until next year we know with certainty what is happening with the tax, we would not choose to invest in the negative NPV but rather save our money, then the expected NPV given

the probability that we wait and the tax happens versus we wait and the tax does not happen = .50 * 6.694 + .5 * $0.80 $2.50 0 = 3.347M = E(NPV1) so E(NPV0) with waiting = 3.347 divided by 1+.13 = 2.962 and

we see that we are much better off to wait and the value of the option to wait is 1.888M.

Please rate me. Thanks a lot.

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