Question

Net Present Value Method—Annuity for a Service Company

Welcome Inn Hotels is considering the construction of a new hotel for $80 million. The expected life of the hotel is 5 years with no residual value. The hotel is expected to earn revenues of $21 million per year. Total expenses, including depreciation, are expected to be $16 million per year. Welcome Inn management has set a minimum acceptable rate of return of 8%. 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- a)- The equal annual net cash flows from operating the hotel = 21million.

b)- Net present value of hotel project = $4 million.

c)- The company should purchase the new hotel because the net present value is positive (ie- $4 million).

Explanation-Net present value = Present value of cash inflows – Total outflows

= ($21 million*3.99271) - $80 million

= $84 million - $80 million

= 4 million

Where- Annual cash inflow = Net income+ Annual depreciation

= $5 million+$16 million

= $21 million

Where- Straight line Method- Annual Depreciation Expense

= (Cost of asset- Salvage value of asset)/No. of useful life (years)

= ($80 million - $0)/5 years

= $16 million

= $260647-$310000

= -$49353

Net income = Revenues – Total expenses

= $21 million - $16 million

= $5 million