The Top Notch Hotel chain is currently considering purchasing a hotel property for $1,000,000. Top Notch’s managers feel that they can bring this hotel up to their high standards with an additional investment of $500,000. They estimate that the hotel property has a beta of 1.5, the return on the market portfolio is 18%, and the risk-free rate is 10%. Top Notch’s tax rate is 40%, its cost of borrowing (kp) is 10%, and the managers intend to finance the hotel using a 50% leverage ratio.
Required:
1. Calculate the kg on the proposed hotel investment.
2. Calculate the k, on the proposed hotel investment.
3. Top Notch’s managers use a WACC approach to NPV. If the hotel has an expected life of 10 years and no salvage value, and if it generates equal after-tax operating cash flows every year, what is the minimum OCF that the hotel will have to generate each of the 10 years to make the investment worthwhile? (The minimum OCF will make NPV equal to zero.)