Investment Timing Option: Option Analysis 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 0.0732 and that the risk-free rate is 5%. 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.
Investment Timing Option: Option Analysis 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 0.0732 and that the risk-free rate is 5%. 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.
Financial Management: Theory & Practice
16th Edition
ISBN:9781337909730
Author:Brigham
Publisher:Brigham
Chapter26: Real Options
Section: Chapter Questions
Problem 3P: Wansley Lumber is considering the purchase of a paper company, which would require an initial...
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Transcribed Image Text:Investment Timing Option: Option Analysis
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 0.0732 and that the risk-free rate is 5%. 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.
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