Question

REAL OPTION ANALYSIS Net present value is static in that cash flows are estimated today and the model makes a decision. In many instances however, changes will impact the project's future success or failure. Examples might be the advent of new technology or different raw material prices. This section illustrates how to make those changes once the project gets underway. But first, let's examine how new information can play a role in decision making. (9) The Sporthotel -Traditional NPV: Hyatt International is now deciding whether or not to build a hotel next to a soon to be built state-of-the-art hockey arena. The hotel is in a city that is one of three vying for an NHL franchise. Hyatt's plan is for the property to be the official hotel of the team. The NHL will announce their franchise decision in exactly one year. If the franchise is granted, the games will begin two years from that point in time, or three years from today. To be the official hotel, the property must be ready for guests when the first game is played. It takes exactly three years to build the hotel. Begin The Hotel Project NHL Makes Franchise Decision Hotel Building Continues Hotel Completed For simplicity sake, we'll remove time value from the analysis by assuming that the discount rate is zero. Unrealistic yes, but the calculations become easier Question: Does the hotel have a positive or negative NPV? [Answer] With a 50% chance that the city gets the franchise, NPV $0 1. Projected outflows from the hotel project (all figures in millions of dollars) First year (Purchase Right, Land, and Permits) Second Year (Construct building shell Third Year: (Finish interior and furnishings) TOTAL $1 $2 $2 $5 2. Projected Inflows from the hotel project (all figures in millions of dollars) If the city gets the franchise the hotel will be worth $8 million when it opens. If the city does not get the franchise the hotel will be worth $2 when it opens. 3. Apply some probability that the NHL awards the city the franchise: Try 50% Inflows.. 50% * ($8) + 50% * ($2)-$5 Million Outflows $1$2 $2 $5 Million NPV =-$5 + $5 = $0 Million

This question is a variant of the Sport Hotel example that was presented in class, in the class notes, and in the Real Option chapter.

The change to consider is this: suppose that the value of the hotel is one of two values: $9.4 million if the city is successful in obtaining the franchise (and not $8 million as in the original problem) or $3.7 if the city is not successful in obtaining the franchise (and not $2 million as in the original problem). All other aspects of the problem are the same as originally presented. Incorporating these new values, and the real option, what is the new NPV of the project?

$ million

Place your answer in millions of dollars using at least three decimal places. For example, the answer of nine hundred seventy five thousand would be entered as 0.975 and not as 975000.

2.This question is a variant of the Sport Hotel example that was presented in class, in the class notes, and in the Real Option chapter. Suppose that in the example, the first year expenditures that include the purchase of plans and permits is not $1 million but instead $1.1 million. All other aspects of the problem are the same as originally presented. Incorporating these new values, and the real option, what is the new NPV of the project?

$ million

Place your answer in millions of dollars using at least three decimal places. For example, the answer of nine hundred seventy five thousand would be entered as 0.975 and not as 975000.

Answer 1

Since this question involves, developing a decision tree, i have provided hand written solution.

Change 1: suppose that the value of the hotel is one of two values: $9.4 million if the city is successful in obtaining the franchise (and not $8 million as in the original problem) or $3.7 if the city is not successful in obtaining the franchise (and not $2 million as in the original problem). All other aspects of the problem are the same as originally presented. Incorporating these new values, and the real option, what is the new NPV of the project?

Please see the figure below. This should help you understand.

Please enter your answer as 1.700

Change 2

The cost in first step is $ 1.10 mn and not $ 1 mn as in the original question. Hence, on abandonment the NPV = Inflow - Outflow = 0 - 1.1 = - $ 1.1 mn

Please see the diagram below.

Please enter your answer as 0.950