Nevada Enterprises is considering buying a vacant lot that sells for $1.2 millio

Question

Nevada Enterprises is considering buying a vacant lot that sells for $1.2 million. If the property is purchased, the company plans to spend an additional $5 million (today) to build a hotel on the property. The cash flows produced by the hotel will depend on whether the state of Nevada imposes a tourism tax in this year’s legislative session. If the tax is imposed, the hotel is expected to produce cash flows of $600,000 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 required return of 12%. a. Given that there is a 50% chance that the tax will be imposed, what is the project’s NPV? b. The company has the option to abandon the project one year from now if the tax is imposed. If it abandons the project, it will sell the complete property 1 year from now for $6 million (net of taxes). Once the project is abandoned, cash flows to the firm will cease. Assuming all cash flows are discounted at 12%, what is the value of the project? c. Assume now that the company does not have the option to abandon the project, BUT it does have the option to purchase an adjacent property in one year at a price of $1.5 million. If the tourism tax is imposed, the PV of cash flows received from developing the property will be $300,000, so it would not make sense to purchase the property. If the tax is not imposed, the PV of the future opportunities from developing the property will be $4 million (as of t=1). If the discount rate is still 12%, what is the project’s value with the addition of this option. 4. A local firm is considering a project with the following cash flows:

Explanation / Answer

The total initial expenditure will be $1.2+$ 5 = $6.2 millions

Pv of project if tax is imposed = 600000(Pvf@12% for 15 yrs)

=600000*6.1944

=$3,716,640

Pv if tax is not imposed  

=1,200,000*6.1944

=$7,433,280

Expected Npv = (0.5*3716640 + 0.5*7433280)- 6,200,000

=5,574,960 - 6,200,000

-$625040 (negative)

since Npv is negative,project cannot be accepted.

B)If the company has the option to abondon the project

the cashflows will be ( 600000 + 6000000)/1.12

=$5,892,857

The value of project will be (5892857-6600000) = -707143(negative)

C)Npv of project at T1 = $4 mill - $1.5 mill =2.5mill

Since probability of not imposing tax is 50% ,Then the Pv at T1 = 2.5mill*0.5 =$1.25 millions

Pv at To = $1.25/1.12 =$1,116,071

The project value after addition of this project will be $1,116,071-$625040 =$491031

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