Real Options: Decision-Tree Analysis

Utah Enterprises is considering buying a vacant lot that sells for $1.4 million. If the property is purchased, the company's plan is to spend another $6 million today (t = 0) to build a hotel on the property. The after-tax cash flows from the hotel will depend critically on whether the state imposes a tourism tax in this year's legislative session. If the tax is imposed, the hotel is expected to produce after-tax cash inflows of $630,000 at the end of each of the next 15 years, versus $1,330,000 if the tax is not imposed. The project has a 12% cost of capital. Assume at the outset that the company does not have the option to delay the project. Use decision-tree analysis to answer the following questions.

What is the project's expected NPV if the tax is imposed? A negative value should be entered with a negative sign. Round your answer to the nearest cent.

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What is the project's expected NPV if the tax is not imposed? A negative value should be entered with a negative sign. Round your answer to the nearest cent.

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Given that there is a 50% chance that the tax will be imposed, what is the project's expected NPV if they proceed with it today? A negative value should be entered with a negative sign. Round your answer to the nearest cent.

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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 would sell the complete property 1 year from now at an expected price of $7.4 million. Once the project is abandoned, the company would no longer receive any cash inflows from it. If all cash flows are discounted at 12%, would the existence of this abandonment option affect the company's decision to proceed with the project today?

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Assume that there is no option to abandon or delay the project, but that the company has an option to purchase an adjacent property in 1 year at a price of $1.5 million. If the tourism tax is imposed, then the net present value of developing this property (as of t = 1) is only $400,000 (so it wouldn't make sense to purchase the property for $1.5 million). However, if the tax is not imposed, then the net present value of the future opportunities from developing the property would be $3 million (as of t = 1). Thus, under this scenario it would make sense to purchase the property for $1.5 million. Given that cash flows are discounted at 12% and that there's a 50-50 chance the tax will be imposed, how much would the company pay today for the option to purchase this property 1 year from now for $1.5 million? A negative value should be entered with a negative sign. Round your answer to the nearest cent.

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