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Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977
Textbook Problem

REAL OPTIONS Nevada Enterprises is considering buying a vacant lot that sells for $1.2 million. If the property is purchased, the company’s plan is to spend another $5 million today (t = 0) to build a hotel on the property. The 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 cash flows of $600,000 at the end of each of the next 15 years. If the tax is not imposed, the hotel is expected to produce cash flows of $1,200,000 at the end of each of the next 15 years. The project has a 12% WACC. Assume at the outset that the company does not have the option to delay the project.

  1. a. What is the project’s expected NPV if the tax is imposed?
  2. b. What is the project's expected NPV if the tax is not imposed?
  3. c. Given that there is a 50% chance that the tax will be imposed, what is the project’s expected NPV if management proceeds with it today?
  4. d. 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 will sell the complete property 1 year from now at an expected price of $6 million after taxes. Once the project is abandoned, the company will no longer receive any cash flows. Assuming that all cash flows are discounted at 12%, will the existence of this abandonment option affect the company's decision to proceed with the project today? Explain.
  5. e. Finally, assume that 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 $1.5 million (outflow at t = 1). If the tourism tax is imposed, the expected net present value of developing this property (as of t = 1) will be only $300,000 (so it doesn't make sense to purchase the property for $1.5 million). However, if the tax is not imposed, the expected net present value of the future opportunities from developing the property will be $4 million (as of t = 1). Thus, under this scenario, it makes sense to purchase the property for $1.5 million (at t = 1). Assume that these cash flows are discounted at 12%, and the probability that the tax will be imposed is still 50%. What is the most the company would pay today (t = 0) for the $1.5 million purchase option (at t = 1) for the adjacent property?

a.

Summary Introduction

To Determine: The expected NPV of the project if the tax is imposed.

Introduction: The net present value is also termed as the discounted cash flow approach is a mainstream capital budget method that considers the time value of cash. It utilizes net present value of the investment as the base to accept or reject a projected investment in projects like buying of new machine, buying of stock or inventory etc.

Explanation

Determine the net present value if the tax is imposed

Using a excel spreadsheet, the net present value if the tax is imposed is determined as -$2,113,481.31.

Excel Spreadsheet:

b.

Summary Introduction

To Determine: The projects’ expected NPV, if the tax is not imposed.

c.

Summary Introduction

To Determine: The projects’ expected NPV, if the management proceeds with it today.

d.

Summary Introduction

To Determine: Whether the existence of the abandonment option affect the company’s decision to proceed with the project today.

e.

Summary Introduction

To Determine: The most the company would pay today.

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