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 $2,710,000 a year at the end of each of the next 5 years. The project's cost of capitl is 11%. a. Calculate the expected net present value of the project. b.The company recognizes that the cash flows could be higher or lower than 2,710,000, depending on whether the host government imposes a facility tax. The company will know in one year whether the tax will be imposed. There is a 30 percent chance that the tax will the imposed, in which case the yearly cash flows will be only $2.5 million. At the same time, there is a 70 percent chance that the tax will not be imposed, in which case the yearly cash flows will be $3.2 million. The company 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 year, the initial investment will remain at $10 million and positive cash flows will continue for 5 years. Assume that all cash flows are discounted at 11 percent. Using decision tree analysis, calculate the value of the real option to wait a year before deciding. c.Discuss 2-3 factors other than 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 + 2.71(1.1^5 - 1)/(0.11*1.11^5) million $ = 1.074 million $ (ANSWER) b) If it goes today, and tax imposed, then expected cash flow = 0.3*2.5 + 0.7*3.2 = 2.99 million $ per year for 5 years. NPV = (1.074+10)*2.99/2.71 -10 = 2.218 million $ If waits 1 year, (i) tax imposed, cash flow = 2.5 million dollar NPV = (1.074+10)*2.99/2.71 -10 = 0.216 million $ It can go ahead as NPV is positive, though lower than we had in (a) above. (ii) tax not imposed. NPV = (1.074+10)*3.2/2.71 -10 = 3.076 million $ Better than at (a) and b(i) above. Expected NPV taking probabilities into account = 0.3*0.216 + 0.7*3.076 =2.218 million $ This is at t=1 Today 's NPV = 2.218/1.1 = 2.016 million $

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