HHR Construction, Inc

question 167

Essay

HHR Construction, Inc. is considering developing, on a piece of land currently held by the company, a new courtyard motel. This project would provide a single payoff from a buyer in one year (after construction was completed). The concept of a courtyard motel is relatively new, so there is a certain amount of risk associated with this project. The company's management feels that in approximately a year from now new information regarding potential consumer demand would be revealed, that is, whether in the chosen geographic location a courtyard motel would be popular (i.e., "good news") or unpopular (i.e., "bad news"). In the former case, you anticipate a selling price of $13 million, while in the latter case only $9 million. At the present, these two outcomes are considered equally likely. For projects of this sort, the company uses a WACC (discount rate) of 10% after tax. The company estimates that total construction costs for this project would, in today's dollars, be approximately $9.7 million.
Required:
1. Based on the given probabilities for the two possible outcomes (states of nature), what is the expected NPV of the proposed investment, rounded to the nearest whole dollar? (At 10%, PV factor for one year = 0.909.)
2. What is the primary deficiency of the traditional DCF analysis you conducted above in Requirement (1)?
3. Suppose now that management has an option to wait a year before deciding whether to construct the motel in question. The question the company is grappling with is whether it should delay the investment decision for one year. Given the information above, what do you recommend, and why? That is, what is the expected NPV of the proposed investment (today) if we waited one year? (For simplicity, assume that one year from now the investment cost would be $9.7 million and that the return one year later would be $13 million.) Round your answer to the nearest whole number.
4. Define the term "real option." Compare real options with financial options.
5. This problem deals with what is called an investment-timing option, one of four general classes of real options. What other types of real options can be embedded in a capital investment proposal? How do these classes relate to put options and call options?

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Definitions:

Lebensraum

A concept from German geopolitics, literally meaning "living space," used to justify expansionist policies by claiming the necessity of acquiring more territory for a nation's growth.

Foreign Policy

A government's strategy in dealing with other nations, involving diplomacy, trade, and military action to achieve national objectives.

Benito Mussolini

An Italian political leader who founded Fascism and ruled Italy as a dictator from 1922 until his downfall in 1943.

Social Order

The organized structure of social relationships and institutions that together compose society.