What is the value of the project with the abandonment option

Reference no: EM132608594

Utah Enterprises is considering buying a vacant lot that sells for $1.2 million. If the property is purchased, the company's plan is to spend another $5 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 $600,000 at the end of each of the next 15 years, versus $1,200,000 if the tax is not imposed. The project has a 12% cost of capital. The company forecasts that there is 50% chance that the tax is not imposed, and 50% chance that the tax will be imposed.

Question 1: What is the expected NPV of the project?

Question 2: Consider the case in which the company has an option to abandon the project 1 year from now if the tax is imposed (After one year, the company knows whether or not the law was passed). If it abandons the project, it would sell the complete property 1 year from now at an expected price of $6 million. Once the project is abandoned, the company would no longer receive any cash inflows from it in the future. If all cash flows are discounted at 12%, what is the value of the project with the abandonment option? Would the option affect the company's decision to proceed with the project today?

Reference no: EM132608594

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