Reference no: EM132620015

Question - 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.

a) What is the project's expected NPV?

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.

b) What is the value of the abandonment option?

c) How does your response to 'b' above highlight shortcomings of traditional NPV analysis?

Let us assume there is no option to delay or abandon the project. Instead, if the tax is not imposed, the company has the option to purchase an adjacent property 2 years from now for $1.5 million. If the property is purchased, there is 65% probability that it will generate additional net cash inflows of $400 000 for each of the remaining years of the project's life (13 years). There is a 35% probability that the cash flows will be $200 000.

d) What is the project's expected NPV if the growth option is incorporated into the calculation?