Keystone Hotels is considering the construction of a new hotel for $120 million. The expected life of the hotel is 30 years

Keystone Hotels is considering the construction of a new hotel for $120 million. The expected life of the hotel is 30 years, with no residual value. The hotel is expected to earn revenues of $47 million per year. Total expenses, including depreciation, are expected to be $32 million per year. Keystone management has set a minimum acceptable rate of return of 14%.

a. Determine the equal annual net cash flows from operating the hotel.

b. Calculate the net present value of the new hotel, using the present value of an annuity of $1 table found in Appendix A. Round to the nearest million dollars.

c. Does your analysis support construction of the new hotel?


Answer:


a. 
in millions 
Annual revenues………………………………………………………………… $47 
Total expenses……………………………………………………………………  $32 
Less noncash depreciation expense*…………………………………………    4 
Annual cash expenses…………………………………………………………   28 
Annual net cash flow…………………………………………………………… $19 
* Annual depreciation expense, $120 million ÷ 30 years = $4 million per year 
b. 
Annual cash flows……………………………………………………………… 
× Present value of an annuity of $1 at 14% for 30 periods……………… 
Present value of hotel project cash flows, rounded……………………… 
Less hotel construction costs………………………………………………… 
Net present value of hotel project…………………………………………… 
* From Appendix A in the text 
(in millions 
except present 
value factor) 
$ 19 
  7.00266 * 
$ 133 
  120 
$  13 
c. The present value of the hotel’s operating cash flows exceeds the construction 
costs by $13 million. That is, the net present value is positive. Therefore, 
construction of the new hotel can be supported by this analysis.