Investment Timing Option: Decision-Tree Analysis Kim Hotels is interested in dev

Question

Investment Timing Option: Decision-Tree Analysis Kim Hotels is interested in developing a new hotel in Seoul. The company estimates that the hotel would require an initial investment of $24 million. Kim expects the hotel will produce positive cash flows of $3.6 million a year at the end of each of the next 20 years. The project's cost of capital is 12%. a. What is the project's net present value? A negative value should be entered with a negative sign. Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answer to two decimal places. $ ______ million. b. Kim expects the cash flows to be $3.6 million a year, but it recognizes that the cash flows could actually be much higher or lower, depending on whether the Korean government imposes a large hotel tax. One year from now, Kim will know whether the tax will be imposed. There is a 50% chance that the tax will be imposed, in which case the yearly cash flows will be only $2.64 million. At the same time, there is a 50% chance that the tax will not be imposed, in which case the yearly cash flows will be $4.56 million. Kim is deciding whether to proceed with the hotel today or to wait a year to find out whether the tax will be imposed. If Kim waits a year, the initial investment will remain at $24 million. Assume that all cash flows are discounted at 12%. Use decision-tree analysis to determine whether Kim should proceed with the project today or wait a year before deciding.

Explanation / Answer

a. Initial investment = 24 million

PV of cash flows = P*(1-(1+r)^-n)/ r

= 3.6*(1-1.12^-20)/ 0.12

= 26.89 million

NPV = 26.89 - 24 = 2.89 million

b. Initial investment after 1 year = 24/ 1.12^1 = $21.43

IF the cash flows are 2.64 million, PV of cash flows will be 2.64* (1-1.12^-19)/ 0.12 = 19.45 million

and

NPV = 19.45 - 21.43 = -1.98 million

IF the cash flows are 4.56 million, the PV of cash flows = 4.56* (1-1.12^-19)/ 0.12

= 33.59 million and

NPV = $12.16 million

Expected value of the project will be 0.5*- 1.98 + 0.5*12.16

= 5.09 million

Kim should wait for a year before deciding since the NPV of the project will be higher in that case.

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