Minicase Chapter 4, Questions 1 and 2

1. Consider the issues of project budget, scope, and project timetable. Discuss the extent to which the CityCenter project reflects survey evidence discussed in the chapter about capital budgeting biases associated with the planning fallacy.
2. Consider whether MGM faced issues in the CityCenter project that could be characterized as sunk costs, and if so, whether they exhibited behavior consistent with escalation of commitment.

Minicase MGM Resorts International: Las Vegas City Center In 2004, the hotel casino company MGM Resorts budget and schedule of Project City Center are still pre- International (MGM) (previously MGM Mirage) initiated liminary, however, and the ultimate timing, cost and scope what would later become the world's largest private sector are subject to risks attendant to large-scale projects. project. They called it City Center, and it would involve By March 2006, the budget for Project CityCenter had a 67-acre complex on the Las Vegas strip with a major grown to $7 billion, as reported in the company's 2005 casino, condominiums, hotels, shops, restaurants, and en- published annual report. This figure excluded the value of tertainment venues. MGM subsequently partnered with underlying land and marketing costs, as well as revenues Dubai World during the construction phase. 47 from sales of condominiums, which were forecasted to be MGM was managed by a very experienced set of $2.5 billion. The majority of the land value at historic cost professionals, who were quite sophisticated about capital was recorded at $40 million. Therefore, they estimated net budgeting. These professionals relied heavily on DCF, en- cost to be $4.5 billion. gaged consultants to assist with cash flow forecasts, and Jim Murren, MGM's CFO at the time, attributed $800 were very detailed in their analyses about a wide range of million of the $3 billion increase to expected inflation, issues, including contract cost management and availabil- and $1.2 billion to the company's decision to increase the ity of labor resources. number of condominiums. In 2004, MGM provided no official budget for Project The condominium decision reflected a rapidly growing CityCenter, but its board approved one, which the com- real estate market. Although construction costs had been ris- pany suggested would be in the vicinity of $4 billion. This ing rapidly across the United States, Murren and City Center amount excluded the sale of an estimated 1,650 condo- President Bobby Baldwin were not concerned, with miniums, which the company envisioned would sell for Baldwin having said: "We have a complete, nailed-down about $1 billion. Thereafter, MGM referred to its budget design scope.":49 In regard to building materials, MGM was as a moving target, raising it to $5 billion in 2005.48 MGM creativefor example, by taking the unconventional step of also added qualifying language stating: The design, making large purchases from Chinese suppliers. The project's primary construction contractor was the Perini Building Company. In respect to design, MGM engaged the services of the highly regarded firms Ehrenkrantz, Eckstut & Kuhn to develop the conceptual master plan for the project and Gensler as executive architect. In all, the company engaged 11 architectural firms for various projects within the overall City Center masterplan complex. They commissioned the renowned design architect Cesar Pelli to produce a design for the main hotel and casino building that would be "paradigm- shifting." By their nature, paradigm-shifting projects are highly complex, and laden with uncertainties. A key risk of the project was "scope creep," a tendency for the archi- tectural scope of the project to increase as the architects worked on the project, thereby leading to cost escalation. In April 2007, MGM revised CityCenter's estimated gross cost to $7.4 billion, and its net cost to $4.7 billion. This increase largely stemmed from the company having decided to expand three of the City Center hotels and to add parking spaces. The motivation for the decision was that between 2004 and 2006, revenues from gambling on the Las Vegas Strip had increased by 21.5 percent, and room rates for hotels had increased by 33.2 percent. Moreover, the company raised its estimates of proceeds from condominium sales to $2.7 billion, noting that buy- ers had already placed $800 million of orders. At the same time, housing estate prices in the United States had peaked in February of 2006, after having been in a speculative bubble since at least 2003 and arguably several years be- fore. As housing prices began to decline, the market for asset-backed commercial paper experienced a run in the summer of 2007 In October 2007, unanticipated complexity with some of the architectural designs led MGM to increase the CityCenter budget to $7.8 billion from $7.4 billion. The increase stemmed from additional steel being needed for the project's mall, Crystals, designed by world-renowned architects Libeskind and Rockwell. At this time, foreclosure rates had begun to increase in comparable markets for second residences, such as in Miami; however, MGM executives expressed no concern about the market for CityCenter condominiums, even though more than 2,600 units that were part of the project represented a very large increase in residential housing for the Strip. Based on previous experience, Las Vegas developers developed the belief that increased supply would generate its own demand: if they built it, buyers would come. This belief would lead MGM to place all of CityCenter's condominiums on the market at once.30 By the end of 2007, Dubai World had invested $4.3 billion in the venture and their contribution was based on a maximum ("capped") cost of $8.5 billion, including con- struction for one component of the project, the Harmon Hotel and Condominiums. In February 2008, MGM revised budgeted costs to $8.7 billion gross and $8 billion net. At this time, the com- pany had begun to experience cancellations at its existing properties, and it predicted a slowdown for the rest of the year. Moreover, as a result of the design process still being in flux, the company had not completed negotiations with its contractors for all of its maximum-price guarantees. MGM also experienced complaints of unsafe working conditions from workers and inspections by the Occupation and Safety and Health Administration, and retrofitted repairs reported by government inspectors detailed concerns that building towers were structurally unsound and did not meet earthquake resilient building code. In 2008 serious construction defects were found in the Harmon, designed by the prominent architect Norman Foster, which resulted in an indefinite halt to that project. At this stage, the Harmon was half-built. It had originally been conceived as having 47 stories, with the hotel on the lower half and condominiums on the upper half. The developers decided to terminate construction at 25 floors and abandoned the plan for 200 condominiums, leaving it as a 400-room hotel. In May 2008, MGM revised the project costs to $9.2 billion gross and $8.5 billion net. Moreover, these figures were not inclusive of all costs. When includ- ing the cost of the land, estimated fair market value of $1.7 billion, preopening expenses of $200 million, $100 million for additional expenses such as brands and management expertise, training and marketing costs, and research and development, the total estimated cost came to $11.2 billion. Moreover, the company had still not fully negotiated a maximum price agreement with all of its contractors. By May 2008, the global financial crisis had already begun to unfold. Although the market for asset-backed commercial paper had stabilized, the investment bank Bear Stearns had collapsed in March, from having been overly exposed to mortgage-backed securities. By May, condominium sales had peaked and begun to slide, while revenues from gambling on the Strip had fallen 16 percent from a year earlier In respect to the budget revisions, perhaps the most sig- nificant issue was the sale of 2,400 condominium units in a collapsed Las Vegas residential market and the leasing of Capital Budgeting 109 the 450,000-square-foot Crystals shopping mall. Relative to its previous forecasts, MGM could not sell as many units as it anticipated, and was forced to decrease prices on the ones it could sell Low initial hotel occupancy also presented a major impact on revenue. As for cost overruns and delays, the underlying issues were varied: they were primarily driven not only by changes in design, but also by the rapidly rising costs of concrete, steel, and labor.52 In September 2008, the full global financial crisis erupted with the bankruptcy of investment bank Lehman Brothers. As a result, MGM found itself unable to obtain several billion dollars of loan financing it had planned to borrow from a consortium led by Bank of America. The company was forced to rely on its own cash, which made it vulnerable to going bankrupt. On December 1, 2008, Jim Murren was named Chairman and CEO of MGM. In March 2009, the company's debt was $14 billion, and it indicated that it was considering bankruptcy. Dubai World filed a lawsuit against MGM seeking relief from its obligations. In April, the two partners reached an agreement allowing the project to continue. The consortium of lenders would provide $1.8 billion in loan financing at an interest rate 2 percent higher than originally negotiated, and MGM would be responsible for absorbing any project costs that exceeded $8.5 billion. In May 2009, MGM announced that it had signed all of the guaranteed maximum price contracts with its con- tractors, and was confident its budget would remain at $8.5 billion In December 2009 City Center opened, but with- out the Harmon hotel, which was not expected to open until late 2010. As part of his statement at the opening in 2009, Murren stated: And while we now stand on far more solid ground, 2009 still served as a wake-up call.... As a company, we begin every day with a new lease on life and a keen sense of optimism, armed with the lessons of the past." MGM adapted to the changed economic environment. Unable to fill Crystals completely with high-end retail es- tablishments, it leased out space temporarily to pop up stores." It rented out unsold condominiums on a short-term basis. Nevertheless, between 2009 and 2012, CityCenter recorded approximately $2.5 billion in impairments related to City Center, roughly 25 percent of the project's cost. Because of its construction flaws, the Harmon Hotel never opened. MGM sued Perini and won the judgment. In 2014, the Harmon was subsequently demolished as a result of the final court order and settlement with Perini. By 2015, MGM had written down 50 percent of its share of the City Center investment. Case Analysis Questions 1. Consider the issues of project budget, scope, and project timetable. Discuss the extent to which the City Center project reflects survey evidence discussed in the chapter about capital budgeting biases associated with the planning fallacy. 2. Consider whether MGM faced issues in the City Center project that could be characterized as sunk costs, and if so, whether they exhibited behavior consistent with "escalation of commitment." 3. Compare the City Center project with specific projects discussed in the chapter, namely: Sony's Chromatron, Syntex's Enrprostil, Motorola's Iridium, Eurotunnel's Channel Tunnel, Boeing's Dreamliner, and Airbus's A380. Your discussion should indicate whether the main psychological phenomena that surfaced in each project also surfaced in the City Center project, as well as commenting on similarities and differences in the comparisons. Minicase MGM Resorts International: Las Vegas City Center In 2004, the hotel casino company MGM Resorts budget and schedule of Project City Center are still pre- International (MGM) (previously MGM Mirage) initiated liminary, however, and the ultimate timing, cost and scope what would later become the world's largest private sector are subject to risks attendant to large-scale projects. project. They called it City Center, and it would involve By March 2006, the budget for Project CityCenter had a 67-acre complex on the Las Vegas strip with a major grown to $7 billion, as reported in the company's 2005 casino, condominiums, hotels, shops, restaurants, and en- published annual report. This figure excluded the value of tertainment venues. MGM subsequently partnered with underlying land and marketing costs, as well as revenues Dubai World during the construction phase. 47 from sales of condominiums, which were forecasted to be MGM was managed by a very experienced set of $2.5 billion. The majority of the land value at historic cost professionals, who were quite sophisticated about capital was recorded at $40 million. Therefore, they estimated net budgeting. These professionals relied heavily on DCF, en- cost to be $4.5 billion. gaged consultants to assist with cash flow forecasts, and Jim Murren, MGM's CFO at the time, attributed $800 were very detailed in their analyses about a wide range of million of the $3 billion increase to expected inflation, issues, including contract cost management and availabil- and $1.2 billion to the company's decision to increase the ity of labor resources. number of condominiums. In 2004, MGM provided no official budget for Project The condominium decision reflected a rapidly growing CityCenter, but its board approved one, which the com- real estate market. Although construction costs had been ris- pany suggested would be in the vicinity of $4 billion. This ing rapidly across the United States, Murren and City Center amount excluded the sale of an estimated 1,650 condo- President Bobby Baldwin were not concerned, with miniums, which the company envisioned would sell for Baldwin having said: "We have a complete, nailed-down about $1 billion. Thereafter, MGM referred to its budget design scope.":49 In regard to building materials, MGM was as a moving target, raising it to $5 billion in 2005.48 MGM creativefor example, by taking the unconventional step of also added qualifying language stating: The design, making large purchases from Chinese suppliers. The project's primary construction contractor was the Perini Building Company. In respect to design, MGM engaged the services of the highly regarded firms Ehrenkrantz, Eckstut & Kuhn to develop the conceptual master plan for the project and Gensler as executive architect. In all, the company engaged 11 architectural firms for various projects within the overall City Center masterplan complex. They commissioned the renowned design architect Cesar Pelli to produce a design for the main hotel and casino building that would be "paradigm- shifting." By their nature, paradigm-shifting projects are highly complex, and laden with uncertainties. A key risk of the project was "scope creep," a tendency for the archi- tectural scope of the project to increase as the architects worked on the project, thereby leading to cost escalation. In April 2007, MGM revised CityCenter's estimated gross cost to $7.4 billion, and its net cost to $4.7 billion. This increase largely stemmed from the company having decided to expand three of the City Center hotels and to add parking spaces. The motivation for the decision was that between 2004 and 2006, revenues from gambling on the Las Vegas Strip had increased by 21.5 percent, and room rates for hotels had increased by 33.2 percent. Moreover, the company raised its estimates of proceeds from condominium sales to $2.7 billion, noting that buy- ers had already placed $800 million of orders. At the same time, housing estate prices in the United States had peaked in February of 2006, after having been in a speculative bubble since at least 2003 and arguably several years be- fore. As housing prices began to decline, the market for asset-backed commercial paper experienced a run in the summer of 2007 In October 2007, unanticipated complexity with some of the architectural designs led MGM to increase the CityCenter budget to $7.8 billion from $7.4 billion. The increase stemmed from additional steel being needed for the project's mall, Crystals, designed by world-renowned architects Libeskind and Rockwell. At this time, foreclosure rates had begun to increase in comparable markets for second residences, such as in Miami; however, MGM executives expressed no concern about the market for CityCenter condominiums, even though more than 2,600 units that were part of the project represented a very large increase in residential housing for the Strip. Based on previous experience, Las Vegas developers developed the belief that increased supply would generate its own demand: if they built it, buyers would come. This belief would lead MGM to place all of CityCenter's condominiums on the market at once.30 By the end of 2007, Dubai World had invested $4.3 billion in the venture and their contribution was based on a maximum ("capped") cost of $8.5 billion, including con- struction for one component of the project, the Harmon Hotel and Condominiums. In February 2008, MGM revised budgeted costs to $8.7 billion gross and $8 billion net. At this time, the com- pany had begun to experience cancellations at its existing properties, and it predicted a slowdown for the rest of the year. Moreover, as a result of the design process still being in flux, the company had not completed negotiations with its contractors for all of its maximum-price guarantees. MGM also experienced complaints of unsafe working conditions from workers and inspections by the Occupation and Safety and Health Administration, and retrofitted repairs reported by government inspectors detailed concerns that building towers were structurally unsound and did not meet earthquake resilient building code. In 2008 serious construction defects were found in the Harmon, designed by the prominent architect Norman Foster, which resulted in an indefinite halt to that project. At this stage, the Harmon was half-built. It had originally been conceived as having 47 stories, with the hotel on the lower half and condominiums on the upper half. The developers decided to terminate construction at 25 floors and abandoned the plan for 200 condominiums, leaving it as a 400-room hotel. In May 2008, MGM revised the project costs to $9.2 billion gross and $8.5 billion net. Moreover, these figures were not inclusive of all costs. When includ- ing the cost of the land, estimated fair market value of $1.7 billion, preopening expenses of $200 million, $100 million for additional expenses such as brands and management expertise, training and marketing costs, and research and development, the total estimated cost came to $11.2 billion. Moreover, the company had still not fully negotiated a maximum price agreement with all of its contractors. By May 2008, the global financial crisis had already begun to unfold. Although the market for asset-backed commercial paper had stabilized, the investment bank Bear Stearns had collapsed in March, from having been overly exposed to mortgage-backed securities. By May, condominium sales had peaked and begun to slide, while revenues from gambling on the Strip had fallen 16 percent from a year earlier In respect to the budget revisions, perhaps the most sig- nificant issue was the sale of 2,400 condominium units in a collapsed Las Vegas residential market and the leasing of Capital Budgeting 109 the 450,000-square-foot Crystals shopping mall. Relative to its previous forecasts, MGM could not sell as many units as it anticipated, and was forced to decrease prices on the ones it could sell Low initial hotel occupancy also presented a major impact on revenue. As for cost overruns and delays, the underlying issues were varied: they were primarily driven not only by changes in design, but also by the rapidly rising costs of concrete, steel, and labor.52 In September 2008, the full global financial crisis erupted with the bankruptcy of investment bank Lehman Brothers. As a result, MGM found itself unable to obtain several billion dollars of loan financing it had planned to borrow from a consortium led by Bank of America. The company was forced to rely on its own cash, which made it vulnerable to going bankrupt. On December 1, 2008, Jim Murren was named Chairman and CEO of MGM. In March 2009, the company's debt was $14 billion, and it indicated that it was considering bankruptcy. Dubai World filed a lawsuit against MGM seeking relief from its obligations. In April, the two partners reached an agreement allowing the project to continue. The consortium of lenders would provide $1.8 billion in loan financing at an interest rate 2 percent higher than originally negotiated, and MGM would be responsible for absorbing any project costs that exceeded $8.5 billion. In May 2009, MGM announced that it had signed all of the guaranteed maximum price contracts with its con- tractors, and was confident its budget would remain at $8.5 billion In December 2009 City Center opened, but with- out the Harmon hotel, which was not expected to open until late 2010. As part of his statement at the opening in 2009, Murren stated: And while we now stand on far more solid ground, 2009 still served as a wake-up call.... As a company, we begin every day with a new lease on life and a keen sense of optimism, armed with the lessons of the past." MGM adapted to the changed economic environment. Unable to fill Crystals completely with high-end retail es- tablishments, it leased out space temporarily to pop up stores." It rented out unsold condominiums on a short-term basis. Nevertheless, between 2009 and 2012, CityCenter recorded approximately $2.5 billion in impairments related to City Center, roughly 25 percent of the project's cost. Because of its construction flaws, the Harmon Hotel never opened. MGM sued Perini and won the judgment. In 2014, the Harmon was subsequently demolished as a result of the final court order and settlement with Perini. By 2015, MGM had written down 50 percent of its share of the City Center investment. Case Analysis Questions 1. Consider the issues of project budget, scope, and project timetable. Discuss the extent to which the City Center project reflects survey evidence discussed in the chapter about capital budgeting biases associated with the planning fallacy. 2. Consider whether MGM faced issues in the City Center project that could be characterized as sunk costs, and if so, whether they exhibited behavior consistent with "escalation of commitment." 3. Compare the City Center project with specific projects discussed in the chapter, namely: Sony's Chromatron, Syntex's Enrprostil, Motorola's Iridium, Eurotunnel's Channel Tunnel, Boeing's Dreamliner, and Airbus's A380. Your discussion should indicate whether the main psychological phenomena that surfaced in each project also surfaced in the City Center project, as well as commenting on similarities and differences in the comparisons