Reference no: EM131101203
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 $5 million today (t =0) to build a hotel on the property. The after-tax 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 after-tax 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 after-tax cash inflows of $1,200,000 at the end of each of the next 15 years. The project has a 12 percent cost of capital. Assume at the outset that the company does not have the option to delay the project. Use decision tree analysis to answer the following questions.
a. What is the project's expected NPV if the tax is imposed?
b. What is the project's expected NPV if the tax is not imposed?
c. Given that there is a 50 percent chance that the tax will be imposed, what is the project's expected NPV if they proceed with it today?
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. Once the project is abandoned the company would no longer receive any cash inflows from it. Assuming that all cash flows are discounted at 12 percent, would the existence of this abandonment option affect the company's decision to proceed with the project today?
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. If the tourism tax is imposed, the net present value of developing this property (as of t =1) is only $300,000 (so it wouldn't make sense to purchase the property for $1.5 million).
However, if the tax is not imposed, the net present value of the future opportunities from developing the property would be $4 million (as of t _ 1). Thus, under this scenario it would make sense to purchase the property for $1.5 million. Assume that these cash flows are discounted at 12 percent, and the probability that the tax will be imposed is still 50 percent. How much would the company pay today for the option to purchase this property 1 year from now for $1.5 million?
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