Problem:
Kanga Resorts is interested in developing a new facility in Asia. The company estimates that the hotel would require an initial investment of $14 million. The company expects that the facility will produce positive cash flows of $2.6 million a year at the end of each of the next 10 years. The project's cost of capitl is 12%.
a. Calculate the expected net present value of the project.
b. The compaqny recognizes that the cash flows could, in fact, be much higher or lower than $2.6 million, depending on whether the host government imposes a large facility tax. One year from now, the company will know whether the tax will be imposed. There is a 40 percent chance that the tax will the imposed, in which case the yearly cash flows will be only $2 million. At the same time, there is a 60 percent chance that the tax will not be imposed, in which case the yearly cash flows will be $3 million. The company is deciding whether to proceed with the facility today or to wait 1 year to find out whether the tax will be imposed. If it waits year, the initial investment will remain at $14 million. Assume that all cash flows are discounted at 12 percent. Using decision tree analysis, calculate the value of the real option to wait a year before deciding.