Suppose you are trying to decide whether you want to undertake a R&D project. The initial investment is $100 million. The upcoming costs are uncertain and there are three possibilities that are equally likely:

• Low cost (of $150 million)
• Medium cost (of $260 million)
• High cost (of $350 million)
• The expected revenue is going to be $350 million the same year the project is initiated.
• The initial investment of $100 million allows you to learn if the cost will be high, medium or low, and allows you make the investment only if it is profitable to invest. If not you abandon the project.

Find the NPV of the project with this embedded optionality. Interest rate is 0%.

options:

- -5 million

- -3.3 million

- 93.3 millon

- 0

It was May 11, 1992, and Kevin Gray was conducting a routine quarterly inspection of the Memphis Airport Wayside Inn. The property was one of those that fell under his jurisdiction as regional general manager for Wayside Inns, Inc. During his inspection tour Gray was called aside by the Inn's manager, Layne Rembert, who indicated some concern about a proposed expansion of his motel. "I'm a little worried, Kevin, about that plan to bring 40 more rooms on stream by the end of the next fiscal year." "Why all the concern, Layne? You're turning away a significant number of customers and, by all indications, the market will be growing considerably." "Well, I've just spoken with Ed Keider. He's certain that the 80-room expansion at the central Toledo property has lowered his return on the investment. I'd really like to chat with you about what effects the planned expansion will have on my incentive compensation and how my income for the year would be affected." The Company Wayside Inns, Inc., located in Kansas City, Missouri, was formed in 1980 as the successor corporation to United Motel Enterprises, a company that operated several franchised motels under licensing agreements from two national motel chains. Because of the complicated and restrictive contract covenants, United was unable to expand the scope of either of their two motel operations through geographical dispersion. The successor corporation was formed to own, operate, and license a chain of motels under the name Wayside Inns, as well as to continue to operate the present franchises held by United. Management felt that the strategy of developing their own motel chain would afford them greater flexibility and would allow them to more easily attain the long-term growth strategies. Another major reason for the move was that the new corporate strategy would allow management to pursue the implementation of a comprehensive marketing plan which they had been slowly developing over the last seven years. The company's fundamental strategy was to cater to those business travellers who were generally not interested in elaborate settings. There were no common areas such as lobbies, convention rooms, bars, or restaurants. The chain emphasized instead clean rooms, dependable service, and rates that generally were 15 to 20 percent lower than other national motel chains. A free-standing restaurant was always located on the motel's property - in some cases it was operated by Wayside. In general, however, concessionary leases were granted to regional restaurant chains. Wayside's management made it a pint to locate their properties near interstate highways or major arteries convenient to commercial districts, airports, and industrial or shopping facilities. In a given City, one would often find Wayside Inns at various strategic locations. This strategy was founded on the belief that it was preferable to have a total of 600 rooms. The strategy resulted in the clustering of hotels in those cities that could support the market. Once several hotels had been built in a particular city, management would seek new properties in region commercially linked to the city. Wayside was well aware that their aggressive strategy was successful only to the extent that unit managers followed corporate policies to the letter. In order to ensure an aggressive spirit among the unit managers a multifaceted compensation plan was developed. The plan was composed of four EXHIBIT 1 Unit Managers' Compensation Package Base Salary Base Salary ranges are calculated on the basis of years of service and relative sales volume for a particular inn. Salaries are subject to annual review and the amount of adjustment will largely depend upon the recommendation of the regional general manager. Every attempt will be made to keep salary levels consistent with competitive chains. Sales Volume Incentive Every unit manager, having earned a profit before taxes, will receive a bonus equal a 1 percent of any revenue increase over the previous year's level. In the event of a revenue decrease, there will be no bonus and the following year's bonus will be calculated using the revenue of the year preceding the decline as a base figure. Return on Investment Bonus Investment will be defined as current assets, fixed assets, other assets, and any deferred expenses. Return is defined as profit before interest expenses and taxes. The formula for the bonus calculation will be: ROI * PF = ROI bonus ROI = EBIT / Investment and PF = Performance factor The performance factor is used to differentiate between the larger and smaller investments and to offset the inherent coplexities of managing the larger properties. Size of Investment ($) Value of Performance Factor ($) $15,000 ........... 0 - 600,000 600.000-1,200,000 $25,000 1,200,000 1,800,000 $36,000 1,800,000 - 2,500,000 $45,000 2,500,000 - up $50,000 Fringe Benefits Each unit manager shall receive an apartment (two bedroom, full kitchen, and den) on the premises, a company car for sales calls, laundry services, and local phone service at no expense. elements, but was basically tied to profitability. A base salary was calculated which was loosely tied to years of service, dollar volume of sales, and adherence to corporate goals. An incentive bonus was calculated on sales volume increases. An additional incentive bonus was calculated using the Inn's return on investment. Fringe benefits were the final element and were a significant factor in the package (See Exhibit 1). Generally, base salaries ranged from $16,000 to $21,000 and total compensation was in the neighborhood of $24,000 to $30,000. The unit manager always lived on the premises and his wife usually played a role in managing the Inn. As a result, the average couple were in their late 40s or beyond. Many did not have previous motel experience. The firm had grown substantially since its inception, and the prospects for future growth were favorable. The company's expansion strategy had evolved into a three-tiered attack. Most importantly, management actively pursued the construction of new motels seeking an ever-widening geographical distribution. Second, 76- and 116-room properties were expanded if analysis demonstrated that they were operating near or at full capacity. Third, old properties that became a financial burden or did not contribute the required rate of return were sold. Wayside Inns were usually constructed in one of three sizes - 76 rooms, 116 rooms, or 156 rooms. Wayside Inns was a public corporation listed on the American Stock Exchange. It had 1,542,850 shares outstanding, with an average float of 400,000 shares. The common stock price had appreciated considerably, and analysts felt that investor interest was due to a number of factors but was primarily linked to their innovative marketing strategy. Wayside's average occupancy rate on established properties was 10 to 20 percent higher than competitive motels. Their specifically targeted market segment (the business traveller) was generally unaffected by seasonal or environmental factors. Additional company strengths, considered significant by service industry analysts, were an aggressive management, reduction of construction costs and completion times due to standardization, and efficient quality control of present properties. The Wayside Inn at Memphis Airport was one of the mid-sized units in the chain - one of the original 116-room properties, It was located at the intersection of Brooks Road and Airways Road, approximately five miles from the center of the city. The motel had opened on February 9, 1984, and had developed a very good following in the succeeding years. While the occupancy rate had averaged near 43 percent for the first year, it had increased steadily over the years. By 1991, it operated at near full capacity for five nights a week. The Inn depended on salesmen and commercial travellers for approximately 80 percent of its revenue. The property had been originally purchased in 1982 for $225,675. Construction costs for the motel had mounted to approximately $923,020, and furnishings, hardware, software, and office equipment had been purchased for $265,500. Wayside Inns had contributed an initial equity capitalization of $75,000. The parent had also loaned $275,000 to the subsidiary which was secured by promissory notes. A national insurance company granted a mortgage of $950,000 on the land and physical plant. Finally, $405,000 had been received from Memphis Interstate Bank to finance equipment and supply purchases and to provide the necessary working capital. (See Exhibits 2 and 3 for operating data and Exhibit 4 and 5 for financial statements.) There were approximately 10 competitive motels, which were franchises of the major national chains, within a two-mile radius of the Memphis Airport Inn. There also existed a number of independent motels within the area. However, they were generally of the budget type and did not offer the quality on which Wayside based their reputation. Recent surveys conducted by the Memphis Chamber of Commerce indicated that average occupancy rates hovered near 72 percent and that the average room sold for $29. Expansion plans by the major chains were expected to account for an additional 800 rooms across the whole city in the following 18 months. Proposed Expansion Wayside's Project Development staff had arrived at a projected schedule of costs that would be associated with the completion of a 40-room expansion. Cost adjustments would be necessary depending on the particular city and conditions. However, variances were not expected to be significant. EXHIBIT 2 Selected Operating Statistics (for the Periods January 1 to December 31) 1991 1990 1989 1988 1987 Occupancy Report Room nights available 41,975 41,975 41,975 41,975 41,975 Occupied room nights 36,634 35,595 33,454 32,613 31,522 87.3 84.8 79.7 77.7 75.1 Occupancy rate (%) Room revenue ($) 998,277 857,839 680,789 577,250 510,656 27.25 24.10 20.35 17.70 16.20 Average room rate ($) Weekly Occupancy (%) Monday 99 89 95 94 92 99 99 99 91 61 63 99 98 97 87 55 59 Tuesday Wednesday Thursday Friday Saturday Sunday Turnaway Tally Monday 26.1 22.8 10.1 11.5 Tuesday 27.7 21.0 16.0 12.1 Wednesday 38.2 33.2 19.5 13.3 Thursday 43.9 36.3 20.4 16.6 Friday 22.6 15.8 5.2 2.4 Saturday 9.6 5.7 2.8 0.2 0.6 Sunday 8.5 6.4 3.0 1.3 0.5 *A turnaway is considered a customer who eighter calls the motel, requests a room in person, or calls central reservation service and is told there are no vacancies. See Exhibit 3 for further data. 94 96 92 72 51 58 92 15.1 19.3 26.9 31.4 10.9 94 87 70 50 91 57 89 86 65 48 55 Engineering and legal fees were expected to be somewhere in the neighborhood of $18,000. Environmental Impact Studies to comply with federal regulations and the local building permits were estimated to cost $12,000. Construction costs for the expansion and a and adjoining parking facility were expected to be near $1,050,000. Such an expansion was expected to generate additional annual, nondirect operating costs of $46,000 (largely for personnel, utilities, and maintenance). Direct room expenses were expected to remain at an average of 23 percent of room revenue. Management and reservation fees paid to the parent were based on a formula of 5 percent of room revenue plus $30 per room per year. Performance Evaluation After dinner that evening, Kevin Gray decided to review his file on Layne Rembert's compensation package and on his related performance evaluation. He checked his records to determine what Rebert's total compensation had been for 1991. He then performed a rough calculation of what it EXHIBIT 3 Daily "Turnaway" Statistics for 1991 Week Sun. Mon. Tues. Wed. Thurs. 1 25 26 36 45 23 21 24 25 10 11 17 23 20 21 16 46 16 17 25 38 20 15 38 43 25 32 45 25 10 12 42 46 21 14 40 71 23 28 39 23 19 25 41 45 25 30 39 46 42 45 28 25 40 30 35 14 63 24 22 45 13 46 49 23 q 4 5 67 503 10 11 12 13 14 15 16 17 - - 443 12 24 58 61 25 26 Fri. - 35 7 10 12022 011 12 15 16 32 43 15 Sat. 4 11 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 20 22 23 24 10 - 1 25 29 15 13 17 18 12 10 25 43 22 42 39 22 28 29 24 30 29 26 25 42 31 32 15 14 17 29 40 55 36 35 33 25 24 20 18 15 66 50 43 25 16 22 25 24 13 61 62 67 50 38 25 15 39 25 PHOTO + 5 = 3 8 8 35 41 62 47 35 28 23 27 61 45 71 68 55 47 35 41 41 35 24 35 82 65 48 50 32 28 26 67 12 10 45 46 39 38 17 25 18 42 45 11 18 16 17 18 20 21 15 2 15 23 36 33 32 - 10 38 27 12 0 15 12 14 23 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 Total 19 18 14 5 16 7 56 55 16 12 23 25 43 39 45 48 45 42 27 40 71 42 35 41 20 47 15 53 18 43 18 20 41 39 19 21 48 53 29 23 19 47 31 24 25 29 20 26 31 33 10 22 16 49 52 15 24 18 40 38 16 21 19 31 41 43 37 45 47 37 35 31 40 38 42 442 1,357 1,440 1,986 2,283 46 65 15 20 23 27 29 31 48 45 7 41 2 25 20 10 43 46 47 52 26 15 6 1,153 16 18 17 6 4 et 4 11 4 16 12 10 00 8 4 2 20 496 would be for 1992 if the additional 40 rooms were to have been available during all this time period (see Exhibit 6). EXHIBIT 4 Memphis Airport Wayside Inn INCOME STATEMENT For the Years Ended December 31 1990 1991 Revenues Room Revenue 857,839 Restaurant rental 29,148 Other 15,798 Total revenues 902,785 Operating costs and expenses Room 194,620 Selling and administrative 204,767 Depreciation and amortization 48,118 Utilities 41.610 998,277 32,304 19,148 1,049,729 229,520 217,020 58,320 45.473 46,6/2 48,498 Maintenance and repairs Management and reservation fees 46,372 53,394 Operating Income 320,626 397,504 Interest expense 159,617 168,610 Profit before taxes 161,009 228,894 Federal taxes 55,746 83,406 Net earnings 105,263 145,488 Over the past few years, Gray had also developed a 20-point performance evaluation report which he used to base his decisions on salary increases (see Exhibit 7). This system was derived from one he had witnessed when he had been previously employed by a national food service organization. While the report had been developed primarily for his own use in helping to determine who should receive merit increases in salary, Gray placed a great deal of weight on his report. In fact, he was entertaining the notion of recommending that it be instituted companywide. He made no bones about letting unit managers know that he looked for other things that pure return on investment. He felt that there notion of recommending that it be instituted companywide. He made no bones about letting unit managers know that he looked for other things that pure return on investment. He felt that there were a number of variables that could seriously affect profitability over which the unit manager had no control. In addition, he believed and efficient operation was toa a large extent contingent on customer satisfaction. EXHIBIT 5 Memphis Airport Wayside Inn BALANCE SHEET Assets Current assets: Cash Trade receivables Merchandise Prepaid expenses: Insurance Mortgage interest Linens Total current assets Fixed Assets Land Building, equipment, furniture and fixtures 1990 19,050 86,825 22,817 4,622 8,524 2,320 144,158 225,675 1,327,740 1991 18,800 101,620 25,312 4,110 8,022 2,480 160,344 225,675 1,370,515 Less: Accumulated Depreciation Total fixed assets Other Assets Franchise Supplies Total other assets Total Assets Current liabilites Accounts payable Taxes payable Accrued expenses Total current liabilities Liabilites (268,375) 1,285,040 12,000 28,540 40,540 1,469,738 68,671 23,240 59,915 151.826 (326,695) 1,269,495 10,500 28,450 38,950 1,468,789 53,066 27,212 52,611 132.889 Total current liabilities Long-term liabilities Mortgage payable Notes payable Notes payable to parent Total long-term liabilities Capital stock Retained earnings Total net worth Total liablities and net worth Net worth 151,826 684,000 302,500 140,000 1,126,500 75,000 116,412 191,412 1,469,738 132,889 646,000 248,000 105,000 999,000 75,000 261,900 336,900 1,468,789 EXHIBIT 6 Effect of Proposed Expansion on Rembert's Income Total Compensation for 1991 Projected Compensation after Expansion Base salary $18,500 Base salary $18,500 Sales volume incentive Sales volume incentive (1,485,859 - 1,049,729) *.01 (1,049,729-902,785) *.01 146,944 *.01 1,469 436,130 * .01 4361 Return on investment bonus Return on investment bonus 397,504/1,468,789 * 36,000 624,235/2,573,789 * 45,000 .2706 * 36,000 9,743 .2425 * 45,000 10914 Total compensation $29,712 Total compensation $33,775 Projected Income Statement (as calculated by Gray) $ 1,420,238 Room revenue Restaurant 40,571 Other 25,050 Total revenues 1,485,859 Operating costs and expenses Room revenue 326,700 Operating expenses 376,832 Depreciation and amortization 82,400 Management and reservation fees 75,692 Operating Income $ 624,235 Remarks: Room revenue projected as 47,184 occupied room nights at an average price of $30.10. This figure is attributed slightly to annual growth but largely to turnaways accommodated. Investment is figured loosely and may vary in actuality, but variance will not significant affect ROI. Questions 1. Is the proposed investment likely to be a good one for Wayside Inns, Inc? 2. Is Layne Rembert's concern justified? 3. Is the current compensation package for inn managers an appropriate one? If not, what would be? 4. Should the performance measurement system for a regional general manager be focused upon the same factors that are used by Kevin Gray and Wayside Inns to evaluate and compensate an inn manager? (An RGM has responsibility for a geographical area containing anywhere from 10 to 15 motels).