Question

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 $20 million. Kim expects the hotel will produce positive cash flows of $3 million a year at the end of each of the next 20 years. The project's cost of capital is 13%.

a. What is the project's net present value?

b. Kim expects the cash flows to be $3 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 $2.2 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 $3.8 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 invest- ment will remain at $20 million. Assume that all cash flows are discounted at 13%. Use decision-tree analysis to determine whether Kim should pro- ceed with the project today or wait a year before deciding.

Answer 1

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Answer:

A.) What is the project net present value? Initial Investment 20 million

Year 10 Cash Flow DF@13% PV 1 3 0.884956 3 0.783147 3 0.69305 3 0.613319 3 0.54276 3 0.480319 3 0.425061 3 0.37616 3 0.332885 3 0.294588 3 0.260698 3 0.230706 3 0.204165 14 3 0.180677 3 0.159891 16 3 0.141496 17 3 0.125218 3 0.110812 19 3 0.098064 3 0.086782 2.65 2.35 2.08 1.84 1.63 1.44 1.28 1.13 1.00 0.88 0.78 0.69 0.61 0.54 0.48 0.42 0.38 0.33 0.29 0.26 11 12 18

21.07 Present value of cash inflow Less: Initial Investment NPV 20 1.07

B. Solution: Initial Investment 20 million Expected Cash flow each year today 3 million Therefore, NPV of the project today if it is accepeted today 1.07 If Kim waits for 1 year the cash flows will be certain

. Year DF@13% If tax is imposed Cash Flow PV If tax is not impose Cash Flow PV 2.2 3. 8 10.884956 2 0.783147 2.2 ကံ ကံ ကံ ကံ ကံ 3.8 ကံ ကံ ကံ ကံ ကံ 2.2 2.2 1.95 1.72 1.52 1.35 1.19 1.06 0.94 0.83 0.73 0.65 0.57 0.51 0.45 0.40 0.35 0.31 0.28 0.24 0.22 0.19 4 0.613319 5 0.54276 6 0.480319 7 0.425061 80.37616 9 0.332885 10 0.294588 11 0.260698 12 0.230706 13 0.204165 14 0.180677 15 0.159891 16 0.141496 17 0.125218 18 0.110812 19 0.098064 20 0.086782 3 .36 2.98 2.63 2.33 2.06 1.83 1 .62 1.43 1 .26 1.12 0 .99 0.88 0.78 0.69 0.61 0.54 0.48 0.42 0.37 | 0.33 2.2 ကံ ကံ ကံ 3.8 2.2 3.8 2.2 3.8 2.2 2.2 2.2 2.2 3.8 3.8 3.8 3.8

15.45 PV of cash flow Less: Initial Investment 20 26.69 20 6.69 -4.55 Thus in this case he will accept the project only if tax is not imposed. Expected NPV after 1 year 3.35 Expected NPV today 2.96 Thus, he should wait for 1 year.