Question

Nevada 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 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 flows of $500,000 at the end of each of the next 15 years. If the tax is not imposed, the hotel is expected to produce cash flows of $1,400,000 at the end of each of the next 15 years. The project has a 12% WACC. Assume at the outset that the company does not have the option to delay the project.

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 55% chance that the tax will be imposed, what is the project’s expected NPV if management proceeds with it today?

d. Although 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 will sell the complete property 1 year from now at an expected price of $6 million after taxes. Once the project is abandoned, the company will no longer receive any cash flows. Assuming that all cash flows are discounted at 12%, will the existence of this abandonment option affect the company’s decision to proceed with the project today? 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 expected 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 12%, and the probability that the tax will be imposed is still 55%. 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?

Answer 1

a

NPV If Tax is imposed

A

Initial cost(1.2+5) million

$6,200,000

Annualcash flow

$500,000

Number of years

15

WACC

12%

B

Present Value of cash inflows

$3,405,432

(Using excelPV function with Rate=12%, Nper=15, Pmt=-500000)

NPV=B-A

Net Present Value(NPV)

($2,794,568)

b

NPV If Tax is NOT imposed

A

Initial cost(1.2+5) million

$6,200,000

Annualcash flow

$1,400,000

Number of years

15

WACC

12%

B

Present Value of cash inflows

$9,535,210

(Using excelPV function with Rate=12%, Nper=15, Pmt=-1400000)

NPV=B-A

Net Present Value(NPV)

$3,335,210

c

Probability that tax will be imposed

0.55

Probability that tax will NOT be imposed

0.45

(1-0.55)

Expected annual cash inflow

$905,000

(0.55*500000+0.45*1400000)

C

Present Value of expected cash flow

$6,163,832

(Using excelPV function with Rate=12%, Nper=15, Pmt=-905000)

NPV=C-A

Net Present Value(NPV)

($36,168)

C

EXISTENCE OF ABANDONEMENT OPTION

Cash Flow fromOperations if tax is imposed

$500,000

D

Present Value of Cash Flow in year 1

$446,429

(500000/1.12)

Cash flow from sales after abandonement

$6,000,000

E

Present Value of sales price

$5,357,143

(6000000/1.12)

F=D+E

TotalPresent Value of cash inflows

$5,803,571

NPV=F-A

Net Present Value

($396,429)

The abandonement option will reduce the loss if tax is imposed