Chapter 13, Problem 7P

### Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250

Chapter
Section

### Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250
Textbook Problem

# REAL OPTIONS Boisjoly Enterprises is. considering buying a vacant lot that sells for $1.4 million. If the property is purchased, the company’s plan is to spend another$6 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 $500,000 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. a. What is the project’s expected NPV if the tax is imposed? b. What is the project’s expected NPV if the tax is not imposed? c. Given that there is a 45% chance that the tax will be imposed, what is the project’s expected NPV if management proceeds with it today? 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 $7 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. 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$1.7 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 $500,000 (so it doesn’t make sense to purchase the property for$1.7 million). However, if the tax Is not imposed, the expected net present value of the future opportunities from developing the property will be $5 million (as of t = 1). Thus, under this scenario, it makes sense to purchase the property for$1.7 million (at t = 1). Assume that these cash flows are discounted at 12%, and the probability that the tax will be imposed is still 45%. What is the most the company would pay today (t = 0) for the $1.7 million purchase option (at t = 1) for the adjacent property? a. Summary Introduction To determine: The expected NPV of the project when the tax is imposed. Introduction: Net present value (NPV) is the variation between the present value of the cash outflows and the present value of the cash inflows. In capital budgeting, the NPV is utilized to analyze the profitability of a project or investment. Explanation Given information: B Company has decided to buy a vacant lot, which is sold for$1,400,000.  The company has planned to purchase the property for $6,000,000. The expected cash flows will be$500,000 at the end of each of the next 15 years when the tax is imposed and the expected cash flows will be \$1,200,000 when the tax is not imposed. The WACC is 12 percent.

Compute the NPV when the tax is imposed:

The table below shows the Excel formula to calculate the NPV:

Note: Refer the P...

b.

Summary Introduction

To determine: The expected NPV of the project when the tax is not imposed.

c.

Summary Introduction

To determine: The expected NPV of the project when the management of the company exceeds the project at the moment.

d.

Summary Introduction

To determine: Whether the existence of the abandonment option affects the decision of the company to proceed with the project.

e.

Summary Introduction

To determine: The amount that the company will pay at the moment.

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