Question

Britton Carter is interested in building a new hotel in Queenstown, New Zealand. His company estimates that the hotel would require an initial investment of $20 million, would produce positive cash flows of $6.5 million a year at the end of each of the next 15 years and can be salvaged (after-tax) for $10 million at t=15. The company recognizes that the cash flows could, in fact, be much higher or lower, depending on whether that area becomes a popular tourist area. It is believed that at the end of two years, a 15 percent chance exists that tourism will NOT be spreading in that direction and yearly cash flows will be only $2.5 million for 15 years with an after-tax salvage value of $7 million, and a 85 percent chance exists that tourism WILL be heading that way and the yearly cash flows will be $8.5 million for 15 years with an after-tax salvage value of $18 million. If the firm waits two years, the initial investment will be $25 million. The project’s cost of capital is 12 percent. Should the firm proceed with the project today or should it wait two years before deciding? (Round NPVs to the nearest dollar. Choose the closest answer.)

	A.	Build it now since the NPV of building today is $1,580,882 better than the NPV for waiting two years.
	B.	Build it now since the NPV of building today is $2,381,340 better than the NPV for waiting two years.
	C.	Build it now since the NPV of building today is $4,122,163 better than the NPV for waiting two years.
	D.	Wait 2 years; the NPV of building today is $2,745,595 worse than the NPV for waiting two years.
	E.	Wait 2 years; the NPV of building today is $3,652,072 worse than the NPV for waiting two years.

Answer 1

B is correct.

Let's calculate the NPV if they build it now using PV function

N = 15, I/Y = 12%, PMT = 6.5, FV = 10 => Compute PV = 46.10 million

NPV = 46.10 - 20 = 26.10 million

If it decides to wait for 2 years,

PMT = 0.15 x 2.5 + 0.85 x 8.5 = 7.60 million and FV = 0.15 x 7 + 0.85 x 18 = 16.35

=> New PV = 54.75 million

NPV after 2 years = 54.75 - 25 = 29.75 million

NPV today = 29.75 / (1 + 12%)^2 = $23.716 million

=> Difference in NPV = 26.10 - 23.716 = 2.381 million