Question

Model 99 Hotels is considering the construction of a new hotel for $80 million. The expected life of the hotel is 20 years with no residual value. The hotel is expected to earn revenues of $15 million per year. Total expenses, including straight-line depreciation, are expected to be $6 million per year. Model 99 management has set a minimum acceptable rate of return of 10%.

1. Determine the equal annual net cash flows from operating the hotel.
$ 13 million

2. Calculate the net present value of the new hotel, using the present value factor of an annuity of $1 at 10% for 20 periods of 8.5136. Round to the nearest million dollars. Enter all amounts as positive numbers.

		(in millions, except present value factor)
Annual net cash flow		$ ______
Present value of an annuity of $1 at 10% for 20 periods	x	8.5136
Present value of hotel project cash flows		$ ______
Less hotel construction costs
Net present value of hotel project		$ _______

3. Which of the following statements is correct regarding this potential project?

a. They should build the hotel because the present value of the hotel's operating cash flows exceeds the construction costs.

b. They should build the hotel because the present value of the hotel's operating cash flows is less than the construction costs.

c. They should build the hotel because the present value of the hotel's operating cash flows is equal to the construction costs.

d. They should not build the hotel because the net present value is negative.

Answer 1

Annual Depreciation = 80/20 = $4 million
1
Equal annual net cash flows = Revenues-(Expenses-Depreciation)
Equal annual net cash flows	13 million	=15-(6-4)
2
	(in millions)
Annual net cash flow	13
Present value of an annuity of $1 at 10% for 20 periods	8.5136
Present value of hotel project cash flows	111
Less hotel construction costs	80
Net present value of hotel project	31
3
They should build the hotel because the present value of the hotel's operating cash flows exceeds the construction costs.