Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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Transcribed Image Text:REAL OPTIONS Boisjoly Enterprises is considering buying a vacant lot that sells for
$1.4 million. If the property is purchased, the company's plan is to spend another $6 million
today (t = 0) to builda hotel on the property. The cash flows from the hotel will depend
critically on whether the state imposes a tourism tax in this year's legislative session. If the
tax is imposed, the hotel is expected to produce cash flows of $500,000 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 12% WACC. Assume at
the outset that the company does not have the option to delay the project.
a. What is the projecť's expected NPV if the tax is imposed?
b. What is the project's expected NPV if the tax is not imposed?
c. Given that there is a 45% chance that the tax will be imposed, what is the project's
expected NPV if management proceeds with it today?
d. Although the company does not have an option to delay construction, it does have the
option to abandon the project 1 year from now if the tax is imposed. If it abandons the
project, it will sell the complete property 1 year from now at an expected price of
$7 million after taxes. Once the project is abandoned, the company will no longer
receive any cash flows. Assuming that all cash flows are discounted at 12%, will the
existence of this abandonment option affect the company's decision to proceed with
the project today? Explain.
e. Finally, assume that there is no option to abandon or delay the project, but that the
company has an option to purchase an adjacent property in 1 year at a price of
$1.7 million (outflow at t = 1). If the tourism tax is imposed, the expected net present
value of developing this property (as of t = 1) will be only $500,000 (so it doesn't make
sense to purchase the property for $1.7 million). However, if the tax is not imposed,
the expected net present value of the future opportunities from developing the proper-
ty will be $5 million (as of t = 1). Thus, under this scenario, it makes sense to purchase
the property for $1.7 million (at t = 1). Assume that these cash flows are discounted at
12%, and the probability that the tax will be imposed is still 45%. What is the most the
company would pay today (t = 0) for the $1.7 million purchase option (at t = 1) for
the adjacent property?
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