Ray Shore has been a very successful hotel general manager for a number of years. One of his long term colleagues, Joan Benning, is trying to start a small hotel asset management company and wants Ray to join her. Joan has actually scouted out a limited service hotel which just renewed their franchise agreement and is located in a tourist area. This hotel has 108 rooms. Her idea is to have Ray operate this hotel for a few years to ramp up the revenue and profit, and then sell it. The current owners are an older couple, and they are looking at retirement; so they are seeking someone to purchase this asset from them. The hotel is associated with a good brand but Joan thinks she needs to put some money into the project just to give the property a fresh look.

Joan gives Ray the following information. The purchase price is $10 million and she has budgeted to spend another $2.1 million in upgrades and remodeling. In addition, an estimated $775,000 of net working capital is expected to be infused into the project. Joan also expect to recover 100% of the net working capital when she sells the property in the future. If the purchase happens today, Joan would like Ray to manage it for 5 years, and she plans to sell the property at the end of year 5. Although there are different rules for depreciating the building itself and also the improvement on the building, to make this calculation simple, Joan uses a straight-line depreciation of 30 years for this analysis with no salvage value. Of course, when Joan sells this at the end of 5 years, the book value of the undepreciated portion will need to be compared to the sale price to determine any gains or losses, and also the tax implicaitons.

With an independent third-party consultant, Joan has determined that the hotel should reach revenues of $3,500,000 at the end of year 1. The consultant also has estimated a slower growth in sales of only 2.5% per year for the two years (year 1 to year 2, year 2 to year 3) but will then be enjoying a strong growth rate of 10% per year until it is sold at the end of year 5. Expenses for the hotel are estimated to be $2,600,000 for the first year with a growth rate of 5% per year.

To finance the entire purchase, Joan will be issuing bonds and will also be using part of her own savings as equity. She is looking at a 65% debt and 35% equity for this deal. She is issuing bonds with a maturity of 5 years, with a 5% coupon rate paying annual interest payments. The estimated sale price of the bond is at $1,100 due to the very attractive coupon rate in todays low interest economy. Joans cost of equity can be estimated using the Capital Asset Pricing Model. Her average tax rate is at 32% and she has a beta of 1.5. The T-bill rate is 1.5% and the market risk premium is at 8%.

Requirements:

Using EXCEL, set up all the given parameters for calculations. Label all variables properly. Then:

1. Calculate the cost of debt, cost of equity, and the weighted cost of capital (15%)

2. Estimate the net cash flows for this project for its entire life (all years) using both the NCF formula (10%) and the regular income statement format (35%)

3. Calculate Payback (5%), Net Present Value (10%), and Internal Rate of Return (10%) and explain the accept/reject decision

4. Determine whether Joan Benning should make this investment under each capital budgeting criterion. Present all calculations and explain the rationale in full sentences and paragraphs such as the definitions of the methods used and how each decision is derived. Grammar and content are both important (15%)

Tips for Project Completion:

1. Initial investment for a project should include all funds needed to start. Therefore, from the purchase price to any upgrades, etc., including any new funds needed to operate the new investment in terms of net working capital should be part of the initial investment in year 0.

2. However, the initial investment amount in item #1 is not the same as the asset itself. Any amount related directly to the asset (cost, remodeling, installation) will be capitalized and will subsequently be depreciated over the life of the project. If any part of it is not fully depreciated when the project is disposed of, then there will be a (a) book value, and there also might be (b) a gain or a loss depending on the sale price of the project when compared to the book value. The gain or loss and the sale price will be incorporated in the very last year of the analysis.

3. The net working capital, which is not part of the asset and therefore has not been depreciated, will need to be added back at the end of the project as it is being recovered. The rationale is that if the project is sold, obviously the net working capital will not be needed to operate this project anymore. Therefore, this amount will be added back in the last year as recovery of net working capital.