The management of a hotel is considering expanding its facilities by providing a gymnasium and spa for the use of guests. It is expected that the additional facilities will result in an increase in the occupancy rate of the hotel and in the rates that can be charged for each room.

The cost of refurbishing the space, which is currently used as a library for guests, and installing the spa is estimated to be $100000.

The cost of the gymnasium equipment is expected to be \($50\) 000.

The gymnasium and spa will need to be refurbished and the equipment replaced every four years. The equipment will be sold for

\($15\) 000 cash at the end of year 4. This amount includes the effect of inflation.

The hotel’s accountants have produced a feasibility report at a cost of \($10\) 000. The key findings from their report, regarding occupancy rates and room rates are as follows:

•Current occupancy rate: 80%

•Number of rooms available: 40

•Current average room rate per night: \($250\) Occupancy rates, following the opening of the gymnasium and spa, are expected to rise to 82% and the average room rate by 5%, excluding the effect of inflation.

The hotel is open for 360 days per year.

Other relevant information from the accountants’ report is listed below:

1 Staffing of the gymnasium and spa

•Number of employees: 4

•Average salary per employee: \($30\) 000 per annum 2 Overheads

•The current budgeted overhead absorption rate for the hotel is \($80\) per square metre per annum. The area required for the gymnasium and spa is 400 square metres.

•The hotel’s overheads are expected to increase by \($42\) 000 directly as a result of opening the gymnasium and spa.

3 Inflation Inflation is expected to be at a rate of 4% per annum and will apply to sales revenue, overhead costs and staff costs. The rate of 4% will apply from Year 2 to each of the subsequent years of the project.

4 Taxation The hotel’s accountants have provided the following taxation information:
•Tax depreciation available on all costs of refurbishing, installation and equipment: 25% reducing balance per annum.
•Taxation rate: 30% of taxable profits. Half of the tax is payable in the year in which it arises, the balance is paid the following year.
•Any losses resulting from this investment can be set against taxable profits made by the company’s other business activities.
The company uses a post-tax money cost of capital of 12% per annum to evaluate projects of this type.
Required:

(a) Calculate the net present value (NPV) of the gymnasium and spa project

(b) Calculate the post-tax money cost of capital at which the hotel would be indifferent to accepting / rejecting the project.

(c) Discuss an alternative method for the treatment of inflation that would result in the same NPV.
Your answer should consider the potential difficulties in using this method when taxation is involved in the project appraisal.