Question

Utah Enterprises is considering buying a vacant lot that sells for $1.8 million. If the property is purchased, the company's plan is to spend another $6 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 $810,000 at the end of each of the next 15 years, versus $1,710,000 if the tax is not imposed. The project has a 14% 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. What is the project's expected NPV if the tax is imposed? Negative value, if any, should be indicated by a minus sign. Do not round intermediate calculations. Round your answer to the nearest cent. $ What is the project's expected NPV if the tax is not imposed? Negative value, if any, should be indicated by a minus sign. Do not round intermediate calculations. Round your answer to the nearest cent. $ Given that there is a 50% chance that the tax will be imposed, what is the project's expected NPV if the company proceed with it today? Negative value, if any, should be indicated by a minus sign. Do not round intermediate calculations. Round your answer to the nearest cent. $ 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 would sell the complete property 1 year from now at an expected price of $7.8 million. Once the project is abandoned, the company would no longer receive any cash inflows from it. If all cash flows are discounted at 14%, would the existence of this abandonment option affect the company's decision to proceed with the project today? Assume 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 $2 million. If the tourism tax is imposed, then 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 $2 million). However, if the tax is not imposed, then 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 $2 million. Given that cash flows are discounted at 14% and that there's a 50-50 chance the tax will be imposed, how much would the company pay today for the option to purchase this property 1 year from now for $2 million? Negative value, if any, should be indicated by a minus sign. Do not round intermediate calculations Round your answer to the nearest cent. $

Answer 1

	A	Cost of land	$1,800,000
	B	Cost of building hotel	$6,000,000
	I=-(A+B)	Total initial cash flow	($7,800,000)
		PROJECTS EXPECTED NPV IF TAX IS IMPOSED
	Rate	Cost of capital	14%
	Pmt	Annual cash flow	$810,000
	Nper	Number of years of cash flow	15
	PV	Present Value of annual cash flows	$4,975,156.07	(Using PV function of excelwith Rate=14%,Nper=15, Pmt=-810000)
	NPV=PV+I	Expected NPV of the project	($2,824,843.93)
		PROJECTS EXPECTED NPV IF TAX IS NOT IMPOSED
	Rate	Cost of capital	14%
	Pmt	Annual cash flow	$1,710,000
	Nper	Number of years of cash flow	15
	PV	Present Value of annual cash flows	$10,503,107.25	(Using PV function of excelwith Rate=14%,Nper=15, Pmt=-1710000)
	NPV=PV+I	Expected NPV of the project	$2,703,107.25
		PROJECTS EXPECTED NPV IF PROCEEDED TODAY
		c	p	v	p*v
			Probability	NPV	Probability*NPV
		Tax Imposed	0.5	($2,824,843.93)	($1,412,421.97)
		Tax Not Imposed	0.5	$2,703,107.25	$1,351,553.63
				SUM	($60,868.34)
		Projects expected NPV if proeeded today	($60,868.34)
		CASH FLOW IF ABANDONED AFTER ONE YEAR
	Fv	Cash flow after one year	$7,800,000
	PV	Present Value of cashflow	$6,842,105.26	(7800000/1.14)
	NPV=PV+I	Net Present Value (NPV)	-$957,894.74
		The project will be abandoned if tax is imposed
		Expected NPV if tax is not imposed	$2,703,107.25
		PROJECTS EXPECTED NPV WITH ABANDONMENT OPTION
		c	p	v	p*v
			Probability	NPV	Probability*NPV
		Tax Imposed	0.5	($957,894.74)	($478,947.37)
		Tax Not Imposed	0.5	$2,703,107.25	$1,351,553.63
				SUM	$872,606.26
		Projects expected NPV with abandonment option	$872,606.26
		Projects expected NPV WITHOUT abandonment option	($60,868.34)
		Yes,Abandonment option does affect the company's decision to proceed with the project today
		With Abandonment option NPV is higher ;Hence company should proceed with the project today