Question

Problem 26-01
Investment Timing Option: Decision-Tree Analysis

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 $2.72 million a year at the end of each of the next 20 years. The project's cost of capital is 12%.

1. 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. Round your answer to two decimal places.
   $ million
   
2. Kim expects the cash flows to be $2.72 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 $1.44 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 $4 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.
   -Select-It makes sense to proceed with the project today.It makes sense to wait a year before deciding.

Answer 1

a. Project's NPV = $4.32 million

Cashflows from year 0 - 10

Cashflows from year 11 - 20

b. NPV today (if project undertaken after a Year) = $3.85 million which is lower than the $4.32 million computed above, therefore:

It makes sense to proceed with the project today.