Hospitality Investment, Inc., spent $250,000 last year for an option to purchase a piece of property for

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Hospitality Investment, Inc., spent $250,000 last year for an option to purchase a piece of property for $1,500,000. Because the option is about to expire, HII is considering the following three courses of action:

1. Buy the land for $1,500,000 and resell it immediately for a guaranteed profit of $500,000.

2. Buy the land and construct a motel.

3. Buy the land and construct a restaurant.

Hil analysts will incorporate any relevant tax considerations into their cal- culations. HI] uses a WACC approach to project evaluation. If the motel or restau- rant is constructed, 60% of the project will be financed with debt at an interest rate of 12%. The risk-free rate is 8% and the expected rate of return on the market port- folio is 18%. Both the motel and the restaurant are estimated to have a beta of 1.4. If either the motel or restaurant project is chosen, operations will be assumed to cease after 10 years, at which time the investment will be sold. It is estimated that the price at which either project can be sold at that time can be approximated by assuming that year ten’s after-tax operating cash flow will be generated in perpetuity from year eleven onward. (The correct discount rate to use is a function of the approach you use to calculate NPV.) The managers assume that the corporate tax rate will be 34% over the 10-year period. All depreciation (which does not include the price of the land) will be calculated on a straight-line basis.

Required:
1. Calculate the owners’ required rate of return for the motel and the restaurant.
2. Calculate the weighted average cost of capital for the motel and the restaurant.
3. Determine the investment outlay for both projects at times 0, 1, and 2.

4. Calculate the annual after-tax operating cash flows for both projects for each year.
5. Calculate the net termination cash flows for each project.
6. Put all of the cash flows for each project on a time line (one time line for each project).
7. Calculate the NPV for each project.
8. Explain which of the three options Hospitality Investments, Inc., should undertake.

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