Question
Arthur Korrey is developing a project to start a new professional aquatic baseballleague, with teams comprised of humans, dolphins and penguins. He forecasts that net
Arthur Korrey is developing a project to start a new professional aquatic baseballleague, with teams comprised of humans, dolphins and penguins. He forecasts that net annual cash flows will be zero for the first two years of the project. But in the third year and subsequent yearsthat cash flows will be high if the sport really catches on. In this case, the value of the league in year 3 would be 900 million.(The 900 million is the PV of the projectCFs from year three on). But if the leagueonly appeals to a small segment of the market, the value would be only 100 million in year 3.(Again, the 100 million is the PV of the project CFs from year 3 on).Arthur estimates that there is a fifty percent chance that aquatic baseballwill catch on, and a fifty percent chance that it will not. Further assume that in year 3, Arthur will know whether or not the league will become popular.The cash flow forecasts discussed above consider all revenues and costs, except for the aquatic stadium. Arthur can sign a perpetual contract with Ocean World amusement park to rent an aquatic stadium for 25 million per year. The25 million rent would be locked in, indefinitely. The risk-adjusted discount rate for the riskycash flows is 14% per year, and the risk-free interest rate is 5% per yearIgnore taxes.
a)What is the NPV of the professional aquatic baseballleague?
b)Suppose that the contract with Ocean World has a cancellation clause.Arthur can cancel the contract after two years. With this clause Arthur would be committed to renting the stadium for two years. Then he could either cancel the contract and dissolve the baseballleague, or he can continue to rent the stadium for 25 million per year. If he does not cancel, then he is committed to renting the stadium in year three and thereafter.
Step by Step Solution
There are 3 Steps involved in it
Step: 1
Get Instant Access to Expert-Tailored Solutions
See step-by-step solutions with expert insights and AI powered tools for academic success
Step: 2
Step: 3
Ace Your Homework with AI
Get the answers you need in no time with our AI-driven, step-by-step assistance
Get Started