Question

Kim Hotels is interested in developing a new hotel in Seoul. The company estimates that the hotel would require an initial investment of $16 million. Kim expects the hotel will produce positive cash flows of $2.56 million a year at the end of each of the next 20 years. The project's cost of capital is 12%.

A) What is the project's net present value? A negative value should be entered with a negative sign. Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Do not round intermediate calculations. Round your answer to two decimal places.

B) Kim expects the cash flows to be $2.56 million a year, but it recognizes that the cash flows could actually be much higher or lower, depending on whether the Korean government imposes a large hotel tax. One year from now, Kim will know whether the tax will be imposed. There is a 50% chance that the tax will be imposed, in which case the yearly cash flows will be only $1.6 million. At the same time, there is a 50% chance that the tax will not be imposed, in which case the yearly cash flows will be $3.52 million. Kim is deciding whether to proceed with the hotel today or to wait a year to find out whether the tax will be imposed. If Kim waits a year, the initial investment will remain at $16 million. Assume that all cash flows are discounted at 12%. Use decision-tree analysis to determine whether Kim should proceed with the project today or wait a year before deciding. Answers: 1) wait a year 2) decide now

Answer 1

A.NPV of the project=

-16+(2.56*7.46944)=             P/A, i=12%; n=20

3.121766

ie. 3.12 mlns

Decision Tree
Now		Wait a yr.
-16&2.56 a yr. for 20 yrs.		50%*(-16 & 1.6 for 19 yrs.)	50%*(-16 & 3.52 for 19 yrs.)

NPV of starting next yr. & tax imposed :

(-16/1.12^1)+(1.6*6.57659)=                  P/A, i=12%,n=2 to 20 years(19 years)

-3.76318

NPV of starting next yr. & tax not imposed :

(-16/1.12^1)+(3.52*6.57659)=

8.863870

If the tax is imposed after 1 year , the NPV of the undertaking is negative. Therefore, it would make no sense to proceed with the construction of the hotel.

Therefore , the NPV of the undertaking after 1 year would be : 50%($0) + 50%($8.86m) = $4.43m

Thus, NPV of the project if we wait for one year($4.43m) is greater than if we started the project right away($3.12 m). So , it makes sense to wait for one year.

Answer : 1) wait a year