First Year:
Purchase of the Right to be the Official Hotel	$50,000
Purchase of Land	$750,000
Purchases of Plans and Permits	$200,000
SUBTOTAL	$1,000,000
Second Year: Construction of the Building Shell	$2,000,000
Third Year: Construction of Building Interior and Furnishings	$2,000,000
TOTAL	$5,000,000

Data Missing:

Now lets assume for simplicity that if the sports franchise is successful the hotel would be a terrific investment and would be worth $8,000,000 when it opened after the third year. However, if the sports franchise is denied, then the hotel will struggle to attract guests and would only be worth $2,000,000. You have been asked to perform a financial analysis of whether the project makes sense.

To start the analysis, assume that there is a 50% chance that the franchise will be received whereby the hotel will be worth $8,000,000 and a 50% chance that the hotel will only be worth $2,000,000. Using these probabilities of the franchises success, the expected value of the benefits of owning the hotel will be halfway between the hotels value in the good state of nature and the hotels value in the bad state of nature, or $5,000,000. Note that the two probabilities need not be set equal to each other, but they must sum to 100%.

In order to make the problem as easy as possible to follow lets assume that interest rates are 0%. This assumption removes the time value of money so that we can ignore having to discount the cash flows and can simply directly compare cash flows at different points in time. Finally, and again to make the problem simple to follow, lets ignore all other risks such as possible increases in building costs or falling revenues.

Since we are ignoring discounting, if there is a 50% chance of the hotel being successful, the expected benefits of building the hotel ($5,000,000) appear to exactly match the costs of building the hotel ($5,000,000). In other words, the project would have a zero expected value. In this case investors should be willing to invest as long as the probability that the franchise is offered is more than 50%.

This question is a variant of the Sport Hotel example that was presented in class, in the class notes, and in the Real Option chapter. Suppose that in the example, the first year expenditures that include the purchase of plans and permits is not $1 million but instead $1.4 million. All other aspects of the problem are the same as originally presented. Incorporating these new values, and the real option, what is the new NPV of the project?

$ million Place your answer in millions of dollars using at least three decimal places. For example, the answer of nine hundred seventy five thousand would be entered as 0.975 and not as 975000.