Question

Investment Timing Option: Option Analysis

Kim Hotels is interested in developing a new hotel in Seoul. The company estimates that the hotel would require an initial investment of $20 million. Kim expects that the hotel will produce positive cash flows of $3 million a year at the end of each of the next 20 years. The project's cost of capital is 13%.

While Kim expects the cash flows to be $3 million a year, it recognizes that the cash flows could, in fact, be much higher or lower, depending on whether the Korean government imposes a large hotel tax. One year from now, Kim 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 be only $2.2 million. 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 $3.8 million. Kim is deciding whether to proceed with the hotel today or to wait 1 year to find out whether the tax will be imposed. If Kim waits a year, the initial investment will remain at $20 million. Assume that all cash flows are discounted at 13%. Use the Black-Scholes model to estimate the value of the option. Assume the variance of the project's rate of return is 5.85% and the risk-free rate is 7%. Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Do not round intermediate calculations. Round your answer to two decimal places.

Use computer software packages, such as Minitab or Excel, to solve this problem.

Answer 1

PV of cash flows:
							calculations
PV1	=	$26,694,056.00	*	0.5	$13,347,028.00		PV(13%,20,-3800000)
PV2	=	$15,454,453.47	*	0.5	$7,727,226.74		PV(13%,20,-2200000)
			Total PV		$21,074,254.73		price of option
	NPV=	$1,074,254.73	or 1.07 million
										c= call option
	Using black schloles
			2434066.889				BLACKSCHOLES("c",F5,20000000,5.85%,7%,1,0)
			=	2.43 million
He should wait for a year since value of option is higher than NPV