Real Options

Baatar Hotels is interested in developing a new hotel in Mongolia. The company estimates that the hotel would require an initial investment of $20M. Baatar expects the hotel will produce positive cash flows of $5M a year at the end of each year for the next 20 years. The project's cost of capital is 12%.

a. What is the NPV?

b. Baatar expects the cash flows to be $4M per year, but it recognizes that the cash flows could actually be much higher or much lower, depending on whether the Mongolian government imposes a large hotel tax. One year from now, Baatar will know whether the tax will be imposed. There is a 50% chance that the tax will be imposed, in which case the yearly cash flows will only be $2.2M. At the same time, there is a 50% chance that the tax will not be imposed, in which case the yearly cash flows will be $7.8M. Baatar is deciding whether to proceed with the hotel today or to wait a year to find out whether the tax will be imposed. If Baatar waits a year, the investment will remain at $20M. Assume that all cash flows are discounted at 12%.

USE decision-tree analysis to determine whether to proceed today or to wait one year.