Investment Timing Option: Option Analysis Activity Frame Kim Hotels is interested in developing a new hotel in Seoul. The company estimates that the hotel would require an initial investment of $20 million. Kim expects the hotel will produce positive cash flows of $3 million a year at the end of each of the next 20 years. The project's cost of capital is 13%. Kim expects the cash flows to be $3 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 $2.2 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 $3.8 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 $20 million. Assume that all cash flows are discounted at 13%. Use the Black-Scholes model to estimate the value of the option. Assume that the variance of the project's rate of return is 0.0585 and that the risk-free rate is 7%. Do not round intermediate calculations. Enter your answer in millions. For example, an answer of $1.234 million should be entered as 1.234, not 1,234,000. Round your answer to three decimal places. Use computer software packages, such as Minitab or Excel, to solve this problem. +A million
Investment Timing Option: Option Analysis Activity Frame Kim Hotels is interested in developing a new hotel in Seoul. The company estimates that the hotel would require an initial investment of $20 million. Kim expects the hotel will produce positive cash flows of $3 million a year at the end of each of the next 20 years. The project's cost of capital is 13%. Kim expects the cash flows to be $3 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 $2.2 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 $3.8 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 $20 million. Assume that all cash flows are discounted at 13%. Use the Black-Scholes model to estimate the value of the option. Assume that the variance of the project's rate of return is 0.0585 and that the risk-free rate is 7%. Do not round intermediate calculations. Enter your answer in millions. For example, an answer of $1.234 million should be entered as 1.234, not 1,234,000. Round your answer to three decimal places. Use computer software packages, such as Minitab or Excel, to solve this problem. +A million
Intermediate Financial Management (MindTap Course List)
13th Edition
ISBN:9781337395083
Author:Eugene F. Brigham, Phillip R. Daves
Publisher:Eugene F. Brigham, Phillip R. Daves
Chapter14: Real Options
Section: Chapter Questions
Problem 4MC
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Question
Transcribed Image Text:Investment Timing Option: Option Analysis
Activity Frame
Kim Hotels is interested in developing a new hotel in Seoul. The company estimates that the hotel would require an
initial investment of $20 million. Kim expects the hotel will produce positive cash flows of $3 million a year at the end
of each of the next 20 years. The project's cost of capital is 13%.
Kim expects the cash flows to be $3 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 $2.2 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 $3.8 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 $20 million.
Assume that all cash flows are discounted at 13%. Use the Black-Scholes model to estimate the value of the option.
Assume that the variance of the project's rate of return is 0.0585 and that the risk-free rate is 7%. Do not round
intermediate calculations. Enter your answer in millions. For example, an answer of $1.234 million should be entered
as 1.234, not 1,234,000. Round your answer to three decimal places.
Use computer software packages, such as Minitab or Excel, to solve this problem.
+A
million
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