Project Valuation I: Simple Hotel Projects

Spiral Galaxy Hotels is considering two different ways to develop a property they

bought for $6.8 million last year. The local hotel market sales are $250 million

annually, and they hope to get 25% of the market if they build a large hotel for $85

million. Alternatively, they could build a smaller, upscale hotel that would only

capture 20% of the market for $45 million. The large hotel would have variable

costs that are 25% of revenue while the upscale variable costs would be 35% of

revenue. The fixed costs are higher for the large hotel at $8 million/year than the

upscale hotel at $3.5 million/year. The large hotel requires additional net working

capital of $1.5 million while the upscale hotel requires $0.9 million. Both hotels

would be depreciated straight-line to zero over ten years, at the end of which the

land could be sold for $7.5 million. The tax rate is 26% for both projects. Assuming

that Spiral Galaxy has a discount rate of 17%, which project should be selected?