Question

Net Present Value Method—Annuity for a Service Company

Welcome Inn Hotels is considering the construction of a new hotel for $63 million. The expected life of the hotel is 8 years with no residual value. The hotel is expected to earn revenues of $19 million per year. Total expenses, including depreciation, are expected to be $13 million per year. Welcome Inn management has set a minimum acceptable rate of return of 11%. Assume straight-line depreciation.

a. Determine the equal annual net cash flows from operating the hotel. Round to the nearest million dollars.
$ million

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. Round to the nearest million dollars. If required, use the minus sign to indicate a negative net present value.
Net present value of hotel project: $ million

c. Does your analysis support the purchase of the new hotel?
, because the net present value is .

Answer 1

Answer to (a)

Straight Line Depreciation = (Cost – Residual Value) / Useful Life

Straight Line Depreciation = (63 – 0) / 8

Straight Line Depreciation per year = $7. 785 Million

Net Operating Income = Revenue – Expenses

Net Operating Income = $19 Million - $13 Million

Net Operating Income = $6 Million

Annual Net Cash Flow = Net Operating Income + Depreciation per year

Annual Net Cash Flow = $6 Million + $7. 875 Million

Annual Net Cash Flow = $13.875 million

Answer to (b)

Required Rate of Return = 11%

Life of Project = 8 years

Net Present Value = - Cost of Investment + Annual Net Cash Flow * PVA of $1 (11%, 8)

Net Present Value = -$63 million +( $13.875 million * 5.14612)

Net Present Value = -$63 million + $71.402million

Net Present Value = $8.402 million

Answer to (c)

Yes, because the Net Present Value is positive.