Calhoun Resorts is interested in developing a new facility in Toronto. The compa

Question

Calhoun Resorts is interested in developing a new facility in Toronto. The company estimates that the hotel would require an initial investment of $10 million. The company expects that the facility will produce positive cash flows of $3,000,000 a year at the end of each of the next 5 years. The project's cost of capital is 12%.

a. Calculate the expected net present value of the project.

b. A hotel tax may be imposed that would affect cash flows. In one year, the company expects to know whether the tax will be imposed. The company believes there is a 40% change that the tax will be imposed, in which case annual cash flows will be $2.5 million. If the tax is not imposed, annual cash flows will be $3.2 million . It is deciding whether to proceed with the facility today or to wait 1 year to find out whether the tax will be imposed. If it waits a year, the initial investment will remain at $10 million, and incoming cash flows will be delayed 1 year. Cost of capital will remain at 12%.

If the company waits one year, calculate the project's NPV in Year 1 with restrictions and without restrictions.

c. Identify 3 qualitative factors in addition to the value of the real option that the company should consider in making its decision.

Explanation / Answer

a)
NPV = - I + a((1+k)^n-1)/(k(1+k)^n
In our case, NPV = - 10 + 3(1.1^5 - 1)/(0.12*1.11^5) million $
= 0.942 million $ (ANSWER)
b)
If it goes today,
and tax imposed, then
expected cash flow = 0.4*2.5 + 0.6*3.2 = 2.92 million $ per year for 5 years.
NPV = (0.942+10)*2.92/3 -10 = 0.65 million $

If waits 1 year,
(i)
tax imposed,
cash flow = 2.5 million dollar
NPV = (0.942+10)*2.5/3 -10 = 0.881 million $
It can go ahead as NPV is positive, though lower than we had in (a) above.
(ii)
tax not imposed.
NPV = (0.942+10)*3.2/3 -10 = 1.67 million $
Better than at (a) and b(i) above.

Expected NPV taking probabilities into account
= 0.4* 0.881 + 0.6*1.67 =1.35 million $

This is at t=1
Today 's NPV = 1.35/1.1 = 1.227 million $

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