Mutually Exclusive Investments: Hamptons Hotel Case Study

Property Description and Background Information The Hamptons Hotel is located in the Hamptons Road area of Virginia Beach, Virginia. The hotel is rated as a 4-diamond hotel based on the United States hotel rating system. The hotel is considered as being unpretentious but luxurious. The Hamptons Hotel is approximately 7 years old. The Hotel consists of 250 guestrooms including 50 premium rooms and 200 standard rooms. Its restaurant seats 150 people, and the lobby bar connects to the restaurant. The only entrance to the hotel is through the lobby bar. In addition, the hotel offers a full range of services to guests, including a large conference and event space for up to 200 people, an exercise room overlooking the ocean, an outdoor pool and recreation area, free parking for guests, and room service. The average annual occupancy is 63%. The Hotels market segments include business, leisure, tour, contract, large groups, and small groups. Three years ago, the Four-Star Hotel Group acquired the Hamptons Hotel. The U.S. publicly traded corporation owns and operates only 4-diamond luxury properties. The Four-Star Hotel Group owns 10 additional 4-diamond properties in various Oceanside locations throughout the U.S. The Four-Star Hotel Group initially paid $31.5 million for The Hamptons Hotel and invested an additional $2.0 million in renovations and furnishings. The Hotel was financed by an exchange of shares with the prior owner and $11.5 million in cash obtained from a bond issue. Restaurant Dilemma Although management has been highly successful in increasing hotel room occupancy and improving overall hotel revenue, the restaurant continues to be unprofitable even with increased food and beverage revenue (See Exhibit 1). After undistributed operating expenses and fixed charges allocated to the restaurant, the restaurant continues to operate at a loss, and it is not capable of absorbing its share of overhead. Unfortunately, the hotel restaurant has followed a trend in the U.S. hotel industry, which began in the 1980s and 1990s. Currently, the hotel restaurant only serves an average of 60% of hotel guests at breakfast and only 22% of hotel guests at dinner. Walk-ins from the outside account for the remaining 7% of total customers served The corporate financial manager and The Hamptons general manager are at odds about the future of the restaurant. The corporate financial manager argues that the company should close the restaurant and offer it to a suitable chain restaurant group under a leasing arrangement. The general manager, however, is certain that if corporate could provide additional funding to construct an access to the restaurant from the street and make the restaurants style trendier, then the hotel restaurant could show profitability in the future. The corporate financial manager has already approached three reputable upscale chain restaurants. The restaurant chains have agreed to review the offer if the Four-Star Hotel Group agrees to construct an entrance with street access to the restaurant. The most feasible of the three is Ricks Steak and Seafood, a very popular upscale restaurant with locations in beachfront cities on the eastern coast of the U.S. The leasing agreement will be for 5 years and provides for $62,000 in lease income each year. Renewal of the lease will be at the option of the Four Star Hotel Group. Therefore, the projections will be based on a 5-year leasing period. The initial investment to provide street accessibility is estimated to cost $950,000. Although Ricks Steak and Seafood will provide alcoholic and non-alcoholic beverages, Ricks has agreed not to operate a bar or lounge area for customers, but it will allow customers waiting for seating or wish to meet in the bar after dining to use the hotels lobby bar. The financial manager has estimated that this will increase the bar revenue net of costs by $9,700 for the first year and an additional increase of 5% per year for each year thereafter. The financial manager also realizes that not all of the overhead charged to the restaurant will be eliminated and other hotel-operated departments will have to absorb some of the overhead costs. His best estimate of the overhead that can be eliminated from the hotel is $200,000 per year. In addition, the financial manager estimates that the working capital required will be reduced by approximately $70,000 per year as a result of lower accounts receivables and lower inventories. Although some portion of existing equipment will be included in the lease, the remaining equipment and furnishings will be sold at a cash gain before taxes of $80,000 (The sale will occur in Year 1 of the lease.) Since the firm has an average tax rate of 25%, the financial manager has completed a schedule of net cash flow from leasing (See Exhibit 2, Proposal 2). The general manager discussed his proposal for renovation and construction of the street access with an architect. In the architects opinion, the cost to renovate the restaurant in an appropriate style and construct the street access would cost $1.8 million. The general manager has also forecasted the increase in potential restaurant revenue and increase in potential restaurant costs for the next 5 years (See Exhibit 2, Proposal 1). The general manager has based his projections on 5 years since corporate has made it clear that if the restaurant remains in-house, then the restaurant must be profitable over the next 5 years. The general manager has also included an additional investment in required working capital based on the increased sales, inventories, and purchases payable (See Exhibit 2, Proposal 1). Although the restaurant will be renovated, some of the older equipment will remain. Therefore, the general manager has included some additional expenditures for future replacement of equipment (See Exhibit 2, Proposal 1). The general manager has applied an average tax rate of 25% to the projected operating cash flows. Additional Information The Four Star Hotel Group has a current price per share of $55 per share. The total number of shares issued and outstanding is 5.5 million. The most recent estimation of the groups beta is 1.0, the average premium on the market is 7.5%, and the risk-free rate of return on short-term U. S. government bonds is 2.2%. The Four Star Hotel Group also has total debt financing of $90 million with an average interest rate on the debt of 4%. Since the Hotel Group consists of only 4-diamond luxury properties, the group considers all of its hotels to have the same average risk as the Hotel Group. For income tax purposes, the original investment for either proposal will be depreciated using the straight-line method based on a 5-year life with no salvage value. The average tax rate for the group is also 25%. Meeting with the Managers You have been requested to consult the Four Star Hotel Group and participate in the meeting in order to make a decision on which investment is the optimal choice, i.e., creates the most value for the shareholders. Before attending the meeting, you are requested to complete the analysis of the mutually exclusive investments. In preparation for the meeting, you will prepare a formal paper analyzing the two investments.

Based on the cost of capital for the Four Star Hotel Group and its average risk assets, which proposal creates more value? In presenting your results, provide justification as to why you have selected one proposal over the other proposal. This will require a discussion of the pros and cons of the valuation methods presented in the proposal