Question

Take a Load Off Hotels is considering the construction of a new hotel for $22,400,000. The expected life of the hotel is 8 years with no residual value. The hotel is expected to earn revenues of $16,688,000 per year. Total expenses, including straight-line depreciation, are expected to be $14,000,000 per year. Take a Load Off's management has set a minimum acceptable rate of return of 12%. Assume straight-line depreciation.

a. Determine the equal annual net cash flows from operating the hotel.
Present Value of an Annuity of $1 at Compound Interest
Periods 8% 9% 10% 11% 12% 13% 14%
1 0.92593 0.91743 0.90909 0.90090 0.89286 0.88496 0.87719
2 1.78326 1.75911 1.73554 1.71252 1.69005 1.66810 1.64666
3 2.57710 2.53129 2.48685 2.44371 2.40183 2.36115 2.32163
4 3.31213 3.23972 3.16987 3.10245 3.03735 2.97447 2.91371
5 3.99271 3.88965 3.79079 3.69590 3.60478 3.51723 3.43308
6 4.62288 4.48592 4.35526 4.23054 4.11141 3.99755 3.88867
7 5.20637 5.03295 4.86842 4.71220 4.56376 4.42261 4.28830
8 5.74664 5.53482 5.33493 5.14612 4.96764 4.79677 4.63886
9 6.24689 5.99525 5.75902 5.53705 5.32825 5.13166 4.94637
10 6.71008 6.41766 6.14457 5.88923 5.65022 5.42624 5.21612
b. Calculate the net present value of the new hotel using the present value of an annuity of $1 table above.
c. Does your analysis support the purchase of the new hotel?

Answer 1

a. Net cash flows

Depreciation has to be added back to income because it is a non-cash expense.

Depreciation = (Cost - Residual value)/ Useful life

= 22,400,000 / 8

= $2,800,000

Net cash flows = Revenue - Expenses + Depreciation

= 16,688,000 - 14,000,000 + 2,800,000

= $5,488,000

b. Net Present Value

= Present value of cash inflows - Construction cost

= (Net cash flows * Present value interest factor of annuity, 8 years, 12%) - 22,400,000

= (5,488,000 * 4.96764) - 22,400,000

= $4,862,408.32

c. Analysis SUPPORTS PURCHASE of hotel because it results in a positive Net Present Value.