Ms. Warren originally approached the company, Desert Mirage Accounting, when she discovered problems with her faulty title to the vacant land. She hired the company to value the hotel property so she could provide lenders an independent appraisal of the collateral value of the property.

Desert Mirage Accounting researched valuation approaches used to determine most banks collateral value of bed and breakfast Inns in the Palm Desert area and discovered that most bank appraisers calculate the collateral value using the expected value approach. They place weights on appraisals that result from two methods. First, many bed and breakfast operations are valued at four times the past two years' average gross margin. Appraisers assume that this appraisal is correct about 40% of the time, and accordingly place a 40% weight on the number derived from this method. Second, many properties are valued by taking the present value of the average of the past three years' cash flows discounted at an 8% discount rate for 10 years. (Appraisers assume that the past cash flows are a good estimate of future cash flows and those cash flows should continue for 10 years in the future.) Appraisers place a weight of 60% on the number derived from this method.

Using the income statement and footnotes for Hotel California for the past three years provided by the existing owner's accountant to help in the appraisal process, verify the value of the hotel determined by Desert Mirage Accounting by using:

a. Four times the past two years' average gross margin

The present value of the average of the past three years' cash flows discounted at 8% for the next 10 years. In order to do this, first prepare an estimate of cash flow from operations for the three years. Then discount the average of this amount at 8% for 10 years to determine the hotel's implied value.

Combine the values calculated in a) and b) using the weights provided. What is the appraised value of the Bed and Breakfast? Assume the appraised value is the total amount that the bank will loan Ms. Warren unless Ms. Warren either pays 25% of the purchase in cash or pledges to the bank a first priority lien on the vacant land as collateral. If Ms. Warren has $500,000 available as a down payment, could she have borrowed enough money based on this appraisal without pledging the vacant land as collateral?

Should Desert Mirage Accounting have relied on the income statement and footnote information provided by Ms. Ramirez's accountant? Why or why not?

HOTEL CALIFORNIA INCOME STATEMENT For the years ended December 31, 2004 2003 2002 Rental Revenue Other Revenues (note 1) $892,513 $796,500 $759,656 171,923 $1,104,945$979,695 $931,579 212,432 183,195 Total Revenues Cost of Revenue (note 2) Gross Profit Marketing General and Administrative (note 3) Operating Income 411,472 419,211 $662,967$568,223 $512,368 93,158 242,211 $265,187$215,533$177,000 441,978 110,495 287,286 97,970 254,721 Notes to Income Statement Note 1: Other Revenues Other revenues consist of charges to guests for charges for other goods and services. Note 2: Cost of Revenue Cost of revenue includes all payroll related costs of employees; depreciation on the property, improvements, and furniture; linen service charges; utilities; and bed taxes. Depreciation in cost of revenue Building (40 year life, Straight line) Property Improvements (various) Furniture (5 year life, Straight line) 2004 $50,000 72,000 88,000 2003 $50,000 68,500 82,000 2002 $50,000 65,000 82,000 Note 3: General and Administrative Expenses General and administrative expenses do not include a salary for S. Ramirez, the owner of the hotel, since this is a sole proprietorship and not a corporation. Ms. Ramirez took drawings of $75,000 in 2004; $72,000 in 2003; and $70,000 in 2002 in addition to the expenses listed above. These amounts approximate what a manager would be paid General and administrative expenses also include depreciation on equipment of $22,000 in 2004; $23,000 in 2003, and $27,000 in 2002