Copyright

Kim hotels is interested in developing a new hotel in Seoul . The company estimates that the...

Question:

Kim hotels is interested in developing a new hotel in Seoul . The company estimates that the hotel would requires 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%.

a. What is the project's 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.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, 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.

Decision Tree Analysis:

A decision tree analysis involves making decisions over several periods. Since these decisions result in particular outcomes, the analysis usually branches out in the shape of a tree.

Answer and Explanation:

a.

Let,

  • NPV = net present value
  • CF = the periodic cash flow,
  • n = the number of periods,
  • r = the interest rate.

The NPV of the project can found as...

See full answer below.

Become a Study.com member to unlock this answer! Create your account

View this answer

Learn more about this topic:

Loading...
What Is a Decision Tree? - Examples, Advantages & Role in Management

from Introduction to Management: Help and Review

Chapter 2 / Lesson 12
156K

Related to this Question

Explore our homework questions and answers library