Investment Timing Option: Decision-Tree Analysis

1. Kim Hotels is interested in developing a new hotel in Seoul. The company estimates that the hotel would require an initial investment of $18 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 15%.

A. What is the project's net present value? Do not round intermediate calculations. Enter your answer in millions. For example, an answer of $1.23 million should be entered as 1.23, not 1,230,000. Round your answer to two decimal places.

$ ____ million

B. 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 $2.1 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 $3.9 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 $18 million. Assume that all cash flows are discounted at 15%. Use decision-tree analysis to determine whether Kim should proceed with the project today or wait a year before deciding.

A. It makes sense to proceed with the project today.

B. It makes sense to wait a year before deciding.

Investment Timing Option: Decision-Tree Analysis

2. The Karns Oil Company is deciding whether to drill for oil on a tract of land that the company owns. The company estimates the project would cost $16 million today. Karns estimates that, once drilled, the oil will generate positive net cash flows of $8 million a year at the end of each of the next 4 years. Although the company is fairly confident about its cash flow forecast, in 2 years it will have more information about the local geology and about the price of oil. Karns estimates that if it waits 2 years then the project would cost $17 million. Moreover, if it waits 2 years, then there is a 90% chance that the net cash flows would be $8.4 million a year for 4 years and a 10% chance that they would be $4.4 million a year for 4 years. Assume all cash flows are discounted at 11%.

A. If the company chooses to drill today, what is the project's net present value? Do not round intermediate calculations. Enter your answer in millions. For example, an answer of $1.23 million should be entered as 1.23, not 1,230,000. Round your answer to two decimal places.

$ ____ million

B. Using decision-tree analysis, does it make sense to wait 2 years before deciding whether to drill?

A. Yes, it makes sense to wait two years to drill.

B. No, it makes sense to drill today.