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 the hotel will

produce positive cash flows of $3 million a year at the end of each of the next 20 years.

The projects cost of capital is 13%.

a. What is the projects net present value?

b. Kim expects the cash flows to be $3 million a year, but it recognizes that the cash

flows could actually 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 a

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 decision-tree analysis to determine whether Kim should proceed with the

project today or wait a year before deciding.

Answer:

Cost of Project :$ 20 Milion

Cash Flow: $ 3 Milion

Life Project: 20 Years

Project Of Capital: 13 % = (0.13)

Problem: What is the projects net present value?

Year PV

1 3/(1+0.13)1=3/(1,330) 2,655

2 3/(1+0.13)2 =3/(1,277) 2,349

3 3/(1+0.13)3 =3/(1,433) 2,349

4 3/(1+0.13)4 = 3/(1,630) 2,079

5 3/(1+0.13)5 = 3/(1,842) 1,840

6 3/(1+0.13)6 = 3/(2,082) 1,628

7 3/(1+0.13)7=3/(2,353)

1,441

8 3/(1+0.13)8=3/(2,658) 1,275

9 3/(1+0.13)9=3/(3,004) 1,128

10 3/(1+0.13)10

=3/(3,395) 0,099

11 3/(1+0.13)11

=3/(3,836) 0,884

12 3/(1+0.13)12

=3/(4,335) 0,782

13 3/(1+0.13)13

=3/(4,898) 0,692

14 3/(1+0.13)14

=3/(5,535) 0,542

15 3/(1+0.13)15

=3/(6,254) 0,480

16 3/(1+0.13)16

=3/(7,067) 0,424

17 3/(1+0.13)17

=3/(7,098) 0,376

18 3/(1+0.13)18

=3/(9,024) 0,332

19 3/(1+0.13)19

=3/(10,197) 0,294

20 3/(1+0.13)20

=3/(11,523) 0,260

Total 21,074

NPV= -20 + 21,074 = 1,074 Mllion

B.

Tax Imposed 50%= $ 2,2 Milion

Tax not Imposed= $ 3,8 Million

Initial Investmen= $ 20 Million

Discounted Rate= 13 % = NP = (1+0,13)=(1,13)

Problems: If Kim wait 1 year, the initial investmen will remain at 20 million. Assume all cash flow are

discounted at 13%. Use Tree analysis to determine whether kim should proceed with project or wait 1

year before deciding

Wait 1 Year

Tax Imposed Prob 50% Tax not Imposed Prob 50%

Year NPV NPV

0 0 - 0 -

1 -20

- -20 -

2 2,2/(1,13)1 1.947 3,8/(1,13)

1 3.363

3 2,2/(1,13)2 1.723 3,8/(1,13)

2 2.976

4 2,2/(1,13)3 1.525 3,8/(1,13)

3 2.634

5 2,2/(1,13)4 1.349 3,8/(1,13)

4 2.331

6 2,2/(1,13)5 1.194 3,8/(1,13)

5 2.062

7 2,2/(1,13)6 1.057 3,8/(1,13)

6 1.825

8 2,2/(1,13)7 0.935 3,8/(1,13)

7 1.615

9 2,2/(1,13)8 0.828 3,8/(1,13)

8 1.429

10 2,2/(1,13)9 0.732 3,8/(1,13)

9 1.265

11 2,2/(1,13)10 0.648 3,8/(1,13)

10 1.119

12 2,2/(1,13)11 0.574 3,8/(1,13)

11 0.991

13 2,2/(1,13)12 0.449 3,8/(1,13)

12 0.877

14 2,2/(1,13)13 0.397 3,8/(1,13)

13 0.776

15 2,2/(1,13)14 0.352 3,8/(1,13)

14 0.687

16 2,2/(1,13)15 0.311 3,8/(1,13)

15 0.608

17 2,2/(1,13)16 0.275 3,8/(1,13)

16 0.538

18 2,2/(1,13)17 0.244 3,8/(1,13)

17 0.476

19 2,2/(1,13)18 0.216 3,8/(1,13)

18 0.421

20 2,2/(1,13)19

0.191 3,8/(1,13)19 0.373

21 2,2/(1,13)20

0.397 3,8/(1,13)20 0.330

Total 15.45 Total 26.694

Tax imposed: NPV @ Yr. 1 = (-20 + 15.45)/(1.13)1 = -4.027

Tax not imposed: NPV @ Yr 1 = (-20 + 26.69)/ (1.13)1 = 5.920

Expected NPV = 0.50(-4.027) + 0.50(5.920) = 0.947

if the tax is imposed, the NPV of the project is negative and therefore would not

be undertaken. The value of this option of waiting one year is evaluated as 0.5($0) + (0.5)($ 5.920)

= $2.96 million.

Since the NPV of waiting one year is greater than going ahead and proceeding with the project today,

it makes sense to wait.