1. What is the project’s NPV, given the projections in Table? 2. Conduct a sensitivity and a scenario analysis of the project. What do these analyses reveal about the project’s risks and potential value?
Radhamohan Gupta, the well-known real estate developer, worked long hours, and he expected his staff to do the same. So Hitesh Chavan was not surprised to receive a call from the boss just as Hitesh was about to leave for a long summer’s weekend.
Mr. Gupta’s success had been built on a remarkable instinct for a good site. He would exclaim “Location! Location! Location!” at some point in every planning meeting. Yet finance was not his strong suit. On this occasion he wanted Hitesh to go over the figures for a new $90 million outlet mall designed to intercept tourists heading down east toward Maine. “First thing Monday will do just fine,” he said as he handed Hitesh the file. “I’ll be in my house in Bar Harbor if you need me.”
Hitesh’s first task was to draw up a summary of the projected revenues and costs. The results are shown in Table.
Note that the mall’s revenues would come from two sources:
✓ The company would charge retailers an annual rent for the space they occupied
✓ In addition, it would receive 5% of each store’s gross sales.
Construction of the mall was likely to take three years.
The construction costs could be
The land was expected to retain its value, but could not be depreciated for tax purposes.
Construction costs, revenues, operating and maintenance costs, and real estate taxes were all likely to rise in line with inflation, which was forecasted at 2% a year.
The company’s tax rate was 35% and the cost of capital was 9% in nominal terms.
Hitesh decided first to check that the project made financial sense. He then proposed to look at some of the things that might go wrong. His boss certainly had a nose for a good retail project, but he was not infallible.
The Salome project had been a disaster because store sales had turned out to be 40% below
What if that happened here? Hitesh wondered just how far sales could fall short of forecast before the project would be underwater.
Inflation was another source of uncertainty. Some people were talking about a zero long-term inflation rate, but Hitesh also wondered what would happen if inflation jumped to, say, 10%.
A third concern was possible construction cost overruns and delays due to required zoning changes and environmental approvals.
Hitesh had seen cases of 25% construction cost overruns and delays up to 12 months between purchase of the land and the start of construction. He decided that he should examine the effect that this scenario would have on the project’s profitability.
“Hey, this might be fun,” Hitesh exclaimed to Mr. Radhamohan’s secretary, Reema, who was heading for Old Orchard Beach for the weekend. “I might even try Monte Carlo.”
“Radhamohan went to Monte Carlo once,” Reema replied. “Lost a bundle at the roulette table. I wouldn’t remind him. Just show him the bottom line. Will it make money or lose money? That’s the bottom line.”
“OK, no Monte Carlo,” Hitesh agreed.
But he realized that building a spreadsheet and running scenarios was not enough.
He had to figure out how to summarize and present his results to Mr. Gupta.
Questions
1. What is the project’s
2. Conduct a sensitivity and a scenario analysis of the project. What do these analyses reveal about the project’s risks and potential value?
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