Vacation Resorts Inc. (VRI) is interested in developing a new hotel in Spain. The company estimates that the hotel would require an initial investment of $32 million. VRI expects that the hotel will prodoce positive cash flows of $5.25 million a year at the end of each of the next 20 years. The project's cost of capital is 14%. While VRI expects the cash flows to be $5.25 million a year, it recognizes that the cash flows could, in fact, be much higher or lower, depending on whether the Spanish government imposes a large hotel tax. One year from now, VRI will know whether the tax will be imposed. There is a 25% chance that the tax will be imposed, in which case the annual cash flows will be only $4.2 million. At the same time, there is a 75% chance that the tax will not be imposed, in which case the annual cash flows will be $5.6 million VRI is deciding whether to proceed with the hotel today or to wait I year to find out whether the tax will be imposed. If VRI waits a year, the initial investment will remain at $32 million. Assume that all cash flows are discounted at 14% Should VRI proceed with the project today or should it wait a year before deciding? a Proceed with the project today, its NPV is $2.77 million, while the NPV of waiting one year is $2.4311 million b. Wait one year, since the NPV of waiting one year is $3.3484 million and this is larger than its NPV of undertaking the project today. c. It doesn't matter whether you go ahead and proceed with the project today or wait one year because their NPVs are identical d. Don't accept the project at all-its NPV today and its NPV if you wait one year are both negative. e. Wait one year, since the NPV of waiting one year is $4.4645 million and this is larger than its NPV of undertaking the project today.
Net Present Value
Net present value is the most important concept of finance. It is used to evaluate the investment and financing decisions that involve cash flows occurring over multiple periods. The difference between the present value of cash inflow and cash outflow is termed as net present value (NPV). It is used for capital budgeting and investment planning. It is also used to compare similar investment alternatives.
Investment Decision
The term investment refers to allocating money with the intention of getting positive returns in the future period. For example, an asset would be acquired with the motive of generating income by selling the asset when there is a price increase.
Factors That Complicate Capital Investment Analysis
Capital investment analysis is a way of the budgeting process that companies and the government use to evaluate the profitability of the investment that has been done for the long term. This can include the evaluation of fixed assets such as machinery, equipment, etc.
Capital Budgeting
Capital budgeting is a decision-making process whereby long-term investments is evaluated and selected based on whether such investment is worth pursuing in future or not. It plays an important role in financial decision-making as it impacts the profitability of the business in the long term. The benefits of capital budgeting may be in the form of increased revenue or reduction in cost. The capital budgeting decisions include replacing or rebuilding of the fixed assets, addition of an asset. These long-term investment decisions involve a large number of funds and are irreversible because the market for the second-hand asset may be difficult to find and will have an effect over long-time spam. A right decision can yield favorable returns on the other hand a wrong decision may have an effect on the sustainability of the firm. Capital budgeting helps businesses to understand risks that are involved in undertaking capital investment. It also enables them to choose the option which generates the best return by applying the various capital budgeting techniques.
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