Norris Gears Inc. owns land with two vacant warehouses which it could sell as is or be rezoned from commercial to light industrial and the buildings upgraded for manufacturing at a cost of $2,450,000 and used for 15 years. There is a 30% chance the rezoning application will be rejected and then Norris will sell the land after one year to make it saleable. If the property is re-zoned Norris estimates a 25% probability that its sales will be $400,000 per year after expenses and before depreciation, a 65% probability that sales will be $300,000 and a 10% that sales will be low at $200,000. If the property is not rezoned and Norris Gears sells the land, there is a 10% probability that the land will be sold this year at $145,000, an 85% probability that the land will go for $115,000 and a 5% probability it goes for $95,000. What is the net present value to Norris of land with warehouses if the company's hurdle rate is 8%?

Question

Quizplus · Accepted Answer

To calculate the net present value (NPV), we need to calculate the present value (PV) of all the cash inflows and outflows, discounted at the hurdle rate of 8%.
1. Rezoning and Upgrading:
PV of Cash Outflows = $2,450,000 (initial investment)
PV of Cash Inflows = $200,000 * 0.1 + $300,000 * 0.65 + $400,000 * 0.25 = $317,500
Expected PV of Cash Inflows = $317,500 * 0.7 (70% chance of success) = $222,250

Net Present Value (NPV) = PV of Cash Inflows - PV of Cash Outflows
NPV = $222,250 - $2,450,000
NPV = -$2,227,750 (negative as the investment does not meet the hurdle rate)

2. Selling the land without rezoning:
PV of Cash Outflows = $0 (no investment required)
PV of Cash Inflows = $95,000 * 0.05 + $115,000 * 0.85 + $145,000 *0.10 = $120,000

Net Present Value (NPV) = PV of Cash Inflows - PV of Cash Outflows
NPV = $120,000 - $0
NPV = $120,000

The best choice is to sell the land without rezoning, which gives a positive NPV of $120,000 and meets the hurdle rate of 8%.