Kim Hotels is interested in de
Kim Hotels is interested in developing a new hotel in Seoul. Thecompany estimates that the hotel would require an initialinvestment of $25 million. Kim expects the hotel will producepositive cash flows of $4 million a year at the end of each of thenext 20 years. The project’s cost of capital is 14%.
- What is the project’s net present value? Do not roundintermediate calculations. Enter your answer in millions. Forexample, an answer of $1.23 million should be entered as 1.23, not1,230,000. Round your answer to two decimal places.
$ million
- Kim expects the cash flows to be $4 million a year, but itrecognizes that the cash flows could actually be much higher orlower, depending on whether the Korean government imposes a largehotel tax. One year from now, Kim will know whether the tax will beimposed. There is a 50% chance that the tax will be imposed, inwhich case the yearly cash flows will be only $2.9 million. At thesame time, there is a 50% chance that the tax will not be imposed,in which case the yearly cash flows will be $5.1 million. Kim isdeciding whether to proceed with the hotel today or to wait a yearto find out whether the tax will be imposed. If Kim waits a year,the initial investment will remain at $25 million. Assume that allcash flows are discounted at 14%. Use decision-tree analysis todetermine whether Kim should proceed with the project today or waita year before deciding.
Answer:
PART A
| Cost of Capital 14% | |||
| Years | Outflow | Inflows | |
| Initial Investment | Year 0 | -25 | |
| Year 1 | 4 | ||
| Year 2 | 4 | ||
| Year 3 | 4 | ||
| Year 4 | 4 | ||
| Year 5 | 4 | ||
| Year 6 | 4 | ||
| Year 7 | 4 | ||
| Year 8 | 4 | ||
| Year 9 | 4 | ||
| Year 10 | 4 | ||
| Year 11 | 4 | ||
| Year 12 | 4 | ||
| Year 13 | 4 | ||
| Year 14 | 4 | ||
| Year 15 | 4 | ||
| Year 16 | 4 | ||
| Year 17 | 4 | ||
| Year 18 | 4 | ||
| Year 19 | 4 | ||
| Year 20 | 4 | ||
| Net Presnet Value | $1.49 |
Conclusion : Thus in the first senario the net present value ofthe project would $1.49 million and the NPV is calcuated usingexcel NPV formula which =NPV(14%,E5:E24)+D4 , refer to the screenshot of the excel sheet I have attached.
PART B
| Cost of Capital 14% | If Tax is Imposed | If Tax is not imposed | |||
| Years | Outflow | Inflow | Outflow | Inflow | |
| Initial Investment | Year 0 | -25 | -25 | ||
| Year 1 | 2.9 | 5.1 | |||
| Year 2 | 2.9 | 5.1 | |||
| Year 3 | 2.9 | 5.1 | |||
| Year 4 | 2.9 | 5.1 | |||
| Year 5 | 2.9 | 5.1 | |||
| Year 6 | 2.9 | 5.1 | |||
| Year 7 | 2.9 | 5.1 | |||
| Year 8 | 2.9 | 5.1 | |||
| Year 9 | 2.9 | 5.1 | |||
| Year 10 | 2.9 | 5.1 | |||
| Year 11 | 2.9 | 5.1 | |||
| Year 12 | 2.9 | 5.1 | |||
| Year 13 | 2.9 | 5.1 | |||
| Year 14 | 2.9 | 5.1 | |||
| Year 15 | 2.9 | 5.1 | |||
| Year 16 | 2.9 | 5.1 | |||
| Year 17 | 2.9 | 5.1 | |||
| Year 18 | 2.9 | 5.1 | |||
| Year 19 | 2.9 | 5.1 | |||
| Year 20 | 2.9 | 5.1 | |||
| Net Present Value | ($5.79) | $8.78 | |||
| Net Present value after 1year | $4.39 |
Conclusion : He should accept the project if the tax is notimposed as it will have a positive NPV. The
NPV of the same after 1 year would be $4.39 million ( as it has50% probablity of happening i.e.50% iof $8.78).
| Expected NPV after 1 year | $4.39 | |
| Expected NPV today | $1.49 |
Thus Kim should wait for 1 year and see if the tax is imposed ornot. { NPV values are calcuated in excel =NPV(14%,J5:J24)+I4 and=NPV(14%,L5:L24)+K4 }
I have attached the excel sheet for your reference.
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