problem: Five years ago you began development of a shopping mall in an upcoming residential area near the town of Superior, CO. You've spent already 20 million dollar [already fully depreciated] on infrastructure and basic structures and now you are about to begin developing the main structure. Demand for shopping mall retail space has declined tremendously over the past two years, and at this point you're not sure whether it's worth going forward with the project. Your analysts have estimated that today the project, in its current state, is worth around 7 million dollar.
If you decide to go forward with the project, you will have to invest an additional 10 million dollar right now. You will be able to depreciate this investment over ten years using the straight-line method. You hope to be done with the construction in one year. If at that point the demand for retail space picks up, you could generate an average of 3 million dollar per year in free cash flows, for the next ten years. Otherwise, this estimate goes down to an average of 1 million dollar per year for the next five years. Assume that you will be able to generate your first rental income the moment you're done building the mall. Assume also that the salvage value of the mall at the end of the operating period [10 years if demand picks up or five years otherwise] is 15 million dollar. It is common knowledge that given the state of the economy today, the likelihood that the demand for retail space next year picks up is 60 percent. Finally, assume that the opportunity cost of capital for this project is ten percent and that your marginal tax rate is 40 percent. Should you abandon or continue with the project? Determine is the NPV of the option to continue?