It has been your secret wish to own and operate an amusement park when you can afford to make the investment. That time has now arrived. There is a large empty lot at the outskirts of Phoenix, Arizona, owned by the city. The city is willing to lease one-half of this lot for 5 years with an option to lease both it and the other half for the next 5 years. In return for charging you a reasonable rent, the city will take ownership of your equipment at the end of the 5 or 10 years.
You have estimated your original investment to be $250,000. You expect your net cash flows (after lease payments, all other expenses, and taxes) to be $55,000 for each of the first 5 years. If you exercise your option to continue with both parts of the property at the end of year 5, you will need to invest another $150,000 (for additional equipment and a miniature golf course). Because your cash flow estimates are now far into the future, you estimate a 50 percent probability that your annual cash flows will remain the same ($55,000) and a 50 percent probability that they will rise to $100,000 per year for the second 5 years. Your cost of capital is 12 percent.
a. Is the first 5-year project acceptable?
b. What is the value of the total project if you exercise your option? What is the value of your option?