Robert Nemeth has owned and operated a lodging operation of 300 rooms for several years and has an opportunity to sell and manage it. Your assignment is to review this opportunity and advise him. You have been given the following information:

The hotel could be sold now for $4,500,000. Its original cost was $4,000,000, and it has been depreciated by $2,000,000.

. The expected annual earnings before depreciation, interest, management fees (EBDIMEF), and taxes of the hotel are $1,000,000.

- The hotel is being depreciated over 20 years on a straight-line basis (for tax purposes) and salvage value is assumed to be zero.

- Mr. Nemeth’s tax rates are 30% for ordinary income and 25% for capital gains.

. The present mortgage on the hotel is $2,000,000 and principal payments of $250,000 are required annually.

. If the hotel is not sold now, Mr. Nemeth believes it could be sold in 10 years for $6,000,000.

. Acontract for the management of the hotel (if it is sold now) has been proposed. The management fee arrangement has not been finalized. Two options are being proposed by Mr. Nemeth as follows:

Option A Option B Basic fee (on rooms revenue) 5% 3%

Incentive fee (on EBDIMF) 10% 15%

. The average expected occupancy of the hotel is 68% and the average room rate is $75 per room sold. Assume all of the rooms are available for sale. Assume the occupancy percentage and ADR will hold constant over the 10-year period.

. If the hotel is managed, annual non-tax operating expenses are estimated at 60% of the total fees.

Assume an annual interest rate of 10%.

Assume Mr. Nemeth’s cost of capital is 12%.

Required:

Evaluate Robert Nemeth’s options to keep or sell and manage the hotel. Within the sale and management option, evaluate options A and B.

Chippewa Hotel Partial Income Statement for Year Ended December 31, 2003 Revenues Expenses Income (Loss)
Rooms $4,800,000 $1,200,000 $3,600,000 Food & Beverages 2,400,000 2,000,000 400,000 Telephone 240,000 224,000 16,000 Other 560,000 240,000 320,000 Total $8,000,000 $3,664,000 $4,336,000 Undistributed Operating Expense 2,300,000 IAUOE $2,036,000 Note: Assume cash flow available after debit payment is $210,000.
1. What is the preferred option for the management company:

a. Basic fee only—5% of gross revenue

b. Basic fee only—the maximum of 4.5% of gross revenue or $42,000/
month