5 – Decision trees When preparing capital budgeting analysis for a new commercia

Question

5 – Decision trees When preparing capital budgeting analysis for a new commercial real estate development, Marcus Butterman, a chief financial officer at WFB Industries, faced a dilemma. He knew his firm had flexibility as to when to undertake the development. It could be done immediately, in 2015. If so, the construction costs would be pretty high due to high demand for construction equipment from other firms. In total, he estimated the complex would cost $2M to build. However, due to significant demand for office space in Northern Milwaukee suburbs, there would be a 70% chance that the building would be rented out starting next year. If so, he expected new cash flow of 500K per year over the next 10 years. There is a 30% chance that the building would not be rented out, however. If he waited one year, until 2016, building costs would drop dramatically, to $1.5M. However, so would the likelihood of renting out the building, to 60%, and the net cash flow, to $450K per year. However, the cash flow would still occur over 10 years. The likelihood that the building would stay vacant would be 40%. Since he has not dealt with uncertainty regarding renting out developments before, Mr. Butterman is bewildered and asks your help in determining the course of action regarding this opportunity. Mr. Butterman has estimated that the WACC for the company in certain times has been 10%. Assume that the project has no tax implications, i.e. the tax rate of 0%.

I awnsered a b and c but I do not know how to solve d)

a) What is the NPV of building in 2015? ____$150598.487______________

b) What is the NPV (in year 2015) of delaying the investment until 2016? ____$144575.5623______________

c) Should the firm invest in the project in 2015, 2016, or not invest at all? _______2015___________

d) What maximum discount (in % relative to the original amount) would Mr. Butterman be willing to provide to the tenants to sign the contract for renting the apartments before he commits to the development of the project? Explain your answer.

Explanation / Answer

Observe that to calculate the amount of the price at which mr butterman will be willing to sign the contract with the tenants, calculate the value of IRR.

Calculate the value of the IRR because it is the value at which the present value of the project is the initial amount invested in the project.

Therefore IRR is the value of maximum discount that mr butterman is willing to provide to the tenants before approving the project.

Therefore the value of maximum discount is the IRR of the project.

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