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Utah Enterprises is considering buying a vacant lot that sells for $1.2 million. If the property is purchased, the company's plan is to spend another $5m today to build a hotel on the property. The after-tax cash flows from the hotel will depend critically upon whether the country imposes a tourism tax in this year's budget. If the tax is imposed, the hotel is expected to produce after-tax 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 after-tax cash inflows of $1 200 000 at the end of each of the next 15 years. The tourism sector has been lobbying vigorously against the tax, and projections are that there is a 70% probability that it will not be imposed.
The project has a 12% cost of capital.
While the company does not have the option to delay construction, it does have to 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 a price of $6 million.
Question 1: What is the value of the abandonment option?
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