Question
What is the appropriate cost of capital of both projects used to to determine the NPV? Suncoast Spa has offered to lease the unused property
What is the appropriate cost of capital of both projects used to to determine the NPV?
Suncoast Spa has offered to lease the unused property with Bridgehampton Shores Inn for 4 years for a monthly rent of $22,000 for the first 2 years, and a 6.5% annual increase for the next two years. The next morning, Marie sets up a meeting with Jim Naruda, the Inns Financial Controller, to discuss Suncoasts offer.
The hotel has to make the space ready for lease. It has to set up the partitions and put in all the necessary plumbing and new flooring. The estimates for the up-front renovation costs range from $225,000 to $275,000 to be depreciated over the life of the project using straight-line with a zero salvage value. Any other spa-related installations will be assumed by Suncoast. The existing elevators and toilets would be used by Suncoast and, therefore, Jim believes that a pro-rata allocation of the costs of the facilities should be based on the area that will be used. He estimates this to be $11,500 per annum. In addition, Jim will also allocate to Suncoast $2,250 per annum for any repair and maintenance costs that will be incurred. Suncoast will pay all utilities and other operating expenses.
If the hotel creates its own spa, the up-front investment is estimated to range between $200,000 to $225,000. Other capital investments will include the installations of whirlpools, sauna, and massage and facial rooms. These additional investments will amount to $145,000. Jim expects revenues to be generated 35% from hotel guests and the other 65% from outside bookings. Total sales are estimated to be $825,000 the first year of operation. Jim comes up with these estimates based on their expected hotel bookings per year and his prediction of demand for spa services from Long Island and the surrounding area.
The project is estimated to last for 6 years. Sales are expected to grow at 4% per year. Jims estimates of the operating costs are as follows: Salaries 25% of Sales Other operating expenses 30% of Sales Depreciation- equipment & furniture Straight-line; zero salve value Capital expenditure Equal annual depreciation Cost of Capital. Bridgehampton Shores Inn has a capital structure consisting of 35% debt and 65% equity. The debt consists of loans from the Long Island Bank with an interest rate of 7.0%. The cost of equity of the hotel shareholders is 16.5%. The corporate tax rate is 40%.The future profits should be discounted at 3.5% which is the average interest rate we earn from our CDs with Long Island Bank.
The projection of net room revenue $2,000,000 $2,200,000 $2,300,000 $2,400,000 $2,450,000 $2,500,000
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