Requirements:

Make sure that the formulas, steps for calculation and explanation should be included in your work

Problem #3 Real Options Boisjoly Enterprises is considering buying a vacant lot that sells for $1.4 million. If the property is purchased, the companys plan is to spend another $6 million today to build a hotel on the property. The cash flows from the hotel will depend critically on whether the state imposes a tourism tax in this years legislative session. If the tax is imposed, the hotel is expected to produce cash flows of $500,000 at the end of each of the next 15 years. If the tax is not imposed, the hotel is expected to produce cash flows of $1,200,000 at the end of each of the next 15 years. The project has a 12% WACC. Assume at the outset that the company does not have the option to delay the project.

a. What is the projects expected NPV if the tax is imposed?

b. What is the projects expected NPV if the tax is not imposed?

c. Given that there is a 45% chance that the tax will be imposed, what is the projects expected NPV if management proceeds with it today?

d. Although the company does not have an option to delay construction, it does have the option to abandon the project 1 year from now if the tax is imposed. If it abandons the project, it will sell the complete property 1 year from now at an expected price of $7 million after taxes. Once the project is abandoned, the company will no longer receive any cash flows. Assuming that all cash flows are discounted at 12%, will the existence of this abandonment option affect the companys decision to proceed with the project today? Explain.