CASE STUDY: LIGHTING THE WAY AT THE MANOR HOUSE HOTEL

Andre and Melissa Barmore met while attending a prestigious East Coast business school. After graduation, Andre worked for several years in hospitality management with a number of well-known luxury hotel brands. Melissa worked in business development with a real estate investment trust (REIT) where she focused on new property acquisition. However, Andre and Melissa had long ago set their sights on owning and managing their own business. The most natural fit for the Barmores was the hotel industry where they could leverage their combined work experience.

In early 2012, all of the pieces began to come together. Melissa had come across a mid - rise 1930s hotel building in the heart of Chicago's Gold Coat. The 100 - room hotel had numerous classic art deco design elements. However, significant refurbishment would be needed in order to realise the Barmores' goal of re-positioning the hotel as a boutique offering that would cater to a high - end clientele. Fortunately, by making use of their extensive contacts in the Chicago real - estate industry, they had been able to obtain financing for the hotel purchase and remodeling project from a large publicly - traded REIT (1). The Barmores hoped to complete the remodeling and to re- open the newly named Manor House Hotel in time for the holidays.

By early November the Barmores had finished re - fitting the hotel's common areas with customised lighting. One of the few remaining decisions concerned the choice of guest-room light bulbs. Although the choice might have seemed minor, the Barmores believed in taking a rigorous approach to all managerial decisions and wanted to set a strong example for their new business.

Lighting technology

Until the 1800s, people relied on fire fed by combustible materials such as wax, whale oil, or kerosene to create visible light (2). Then in 1752, the world began to change rapidly after Benjamin Franklin' famous kite flying experiment ushered in the electrical age. By 1802, Humphry Davy had created the first incandescent light bulb that could be commercialized. The incandescent light bulb is still with us today, but several newer technologies have emerged that may soon displace the incandescent bulb.

Incandescent Light Bulbs

Incandescent bulbs produced light by running electric current through a filament wire that was resistant to the flow of electricity. The resistance caused the filament to heat up until it glowed, releasing visible light. This process, known as incandescence, produced around 15 lumens of light per watt of electricity (3) a typical incandescent bulb cost around fifty cents and had a rated life of 1,000 hours - meaning that after 1,000 hours of use, 50% of bulbs failed when the filament burned out (see Exhibit 2). Incandescent bulbs were not particularly energy efficient: only 10% of the energy input of an incandescent bulb was converted into visible light with the rest being converted into heat. However, incandescent bulbs produced light that most people found pleasing because it closely mimicked sunlight and rendered colours accurately. As a result, incandescent bulbs still comprised roughly 75% of the market for light bulbs in 2012, even after 130 years of market dominance (4).

Compact Fluorescent Bulbs

Compact fluorescent bulbs (CFLs) were introduced in the late 1970s in response to rising energy costs and comprised roughly 20% of the light bulbs market by 2012 (5,6). CFLs created light by running electric current through curled glass tubes that contained mercury vapor. The current excited the vapor, causing it to emit ultraviolet radiation. This ultraviolet radiation was then converted to visible light by a phosphorous coating on the inside of the tubes in a process known as fluorescence. Because CFLs had no heated filament they tended to last far longer, with rated lives ranging from 8,000 to 12,000 hours (see Exhibit 2) (7). CFLs were also energy efficient, emitting 60 lumens of light per watt of electricity. Furthermore, CFLs were fairly inexpensive: a CFL that produced the same amount of light as a 60-watt incandescent bulb cost about $5 in 2012. Despite these positive attributes, CFLs had a negative reputation in the market. Specifically, many people thought that CFLs flickered or buzzed, produced light that rendered colores poorly, and took time to warm up to full brightness. Finally, CFLs contained small amounts of mercury, which created some disposal concerns.

Light Emitting Diode Bulbs

Light Emitting Diodes (LEDs) created light through a process known as electroluminescence whereby electrons were forced to flow through small holes, which caused the release of photons (8). LEDs were fist discovered in 1907 when an experimenter at Marconi Labs found that certain crystals emitted light when an electric current was run through them. It was not until the 2000's, however, that LEDs found their way into general lighting applications. Although the materials used in LEDs were rapidly improving, the technology already allowed for bulbs that were very energy efficient, closely mimicked the light quality of incandescent bulbs, and turned on instantly. LEDs did not burn out but slowly dimmed over time. Thus, LEDs were assumed to be at the end of their rated life when they generated 70% of their initial lumen output, which for most LED bulbs was around 24,000 hours (see Exhibit 2). While their performance was quite impressive, an LED that produced the same amount of light as a 60-watt incandescent bulb was still quite expensive, selling for between $10 and $25 in 2012. However, prices for LEDs were projected to fall by 25% per year until 2015, and then by 12.5% per year until 2020 (9). Furthermore, LED energy efficiency was projected to rise from 65 lumens per watt currently to over 150 by 2020 (10). Accordingly, LED technology , which comprised less than 5% of the lighting market in 2012, was expected to rise to over 70% of the market by 2020 (11).

Making a Choice

Based on the data provided in Exhibits 1 and 2, the Barmores had decided to begin their analysis by considering the following alternatives:

i) Exclusive use of 60 watt incandescent bulbs.

ii) Exclusive use of 60 watt equivalent CFL bulbs.

iii) Exclusive use of 60 watt equivalent LED bulbs.

In coming to a decision, the Barmores knew that the best choice would be the alternative which offered the lowest cost in present value terms without compromising the hotel's quality standards. For reasons of practicality, the Barmores had decided that any purpose costing less than $20,000 would be immediately expensed, rather than being depreciated over the estimated life of the investment (12). However, they knew that reaching a decision would require consideration of more than the initial purchase price of the bulbs. Specifically, the Barmores knew they also needed the forecast the annual stream of expected future costs for each of the alternatives. In this regard, the Barmores anticipated that the price of electricity, the price of new incandescent bulbs and the replacement labor cost for incandescent bulbs would each grow in line with overall inflation, which was expect to average 2% per annum going forward (13). For simplicity, the Barmores had also decided to assume that all bulbs would have to be replaced as soon as they reached their rated lifetime. Furthermore, the Barmores had recently heard about the near-tem possibility of a permanent on-time 20% rate hike by their local utility. As a result, they were interested in whether their choice might be affected by such a near-term jump in utility rates.

Finally, after consulting with the publicly-traded REIT that was providing the financing for the project, the Barmores had determined that the appropriate discount rate for the guest-room lighting purchase and other capital investments in the Manor House Hotel was 10%. Specifically, analysts at the REIT had determined that its base of broadly diversified investors was currently requiring a 10% return for investments with similar risks and a similar time horizon to investments in hotel development.

Read the case Ligthing the Way at the Manor House Hotel, and calculate the present value among the four types of bulbs. Determine which bulb you would choose and why.

1. Excel table showing the calculation of the present values of the four alternatives as well as the assumptions taken (20 pts each = total 80 points)

2. Summary of the present values and choice of the bulb (20 pts)