The owner of Pinnacle Golf Hotel, Golden Drinks plc, has a dilemma. The company wishes to sell the hotel but believes it would be worth a lot more, given its location, if it were first upgraded from three to four star. This would require a major investment programme which would cause some disruption.

The Pinnacle Golf has 40 double bedrooms which are occupied 250 nights per year on average and for which the charge is 100 per room per night. However, during the refurbishment, however long it takes, the occupancy rate is expected to fall to 200 nights per year on average due to rooms being out of action. The hotels operating costs are 900,000 pa and these will be unaffected. Assume both income and costs occur at year-ends.

The refurbishment will take between two and three years and will cost a total of 600,000. When this is paid depends on how long the work takes, in the following way.

Payments at end of year Duration of Work (000)

2 years 3 years

1. 300 200
2. 300 200
3. - 200

Golden Drinks could sell the hotel now as a three star for 600,000. It expects to be able to sell it as a four star for 1.8m, but this decision means that it loses the 600,000 now. Its cost of capital is estimated to be 16% pa. Ignore inflation and taxation.

(a) Construct a cash flow forecast and calculate the net present value (NPV) of the decision to invest, assuming that the refurbishment takes three years. Advise Golden Drinks whether they should sell now or invest and sell after three years. (b) On further investigation, the construction company about to be awarded the contract estimates that there is an 80% chance that the work will take two years and a 20% chance that it will take three years. Determine the NPV of the decision to invest in light of this new information. (c) Suppose Golden Drinks decides not to invest but is contemplating keeping Pinnacle Golf after all as a three star for a further 15 years, after which it would only be worth 500,000. Determine the Net Present Value of the hotel on this basis and advise whether Golden Drinks should sell, refurbish and then sell or keep the hotel.