Question

A young entrepreneur is planning to open a budget hotel with a start-up capital of RM 300,000. The hotel will have single-bed rooms with an expected rate of RM 80 per room. An average room occupancy rate is about 210 per month.    Annual operating expenses for which cover administration, utility and maintenance costs are about RM 80,000. The cash flows will be expected to remain unchanged for the next 10 years. The applicable tax rate is 30% and a total of 10,000 in tax-deductible depreciation are allowed every year.

b. Calculate the payback period if the after-tax rate of return of 20 % is expected.

c. If the after tax minimum attractive rate of return of 30 % per year is required, what is the new room rate?        

Answer 1

1. Present Value (PV) of Cash Outfow is the start up capital, i.e. RM 300,000.

2. Now, let us calculate the Present Value of the Cash Inflows:

Revenue for the year = Room occupancy per month x Rate per Room x No. of Months

= 210 x 80 x 12 = RM 201,600

Profit Before Tax (PBT) = Revenue - Operating Expenses - Depreciation - Other Expenses - Interest Costs

= RM 201,600 - RM 80,000 - RM 10,000 - 0 - 0 = RM 111,600

Profit After Tax (PAT) = PBT (1 - Tax Rate) = RM 111,600 (1 - 0.30) = RM 78,120

Cash Flow for the period (CF) = PAT + Depreciation = RM 78,120 + RM 10,000 = RM 88,120

We add back the depreciation since it is not a cash expenses and there is no outflow of cash. However, depreciation enables us to obtain the benefit of reduced tax.  

The question states that cash flows are expected to remain unchanged for the next 10 years.  

3. Answering the requirements:

b. We are given the expected rate of return of 20%. Hence, we will use the Discounted Payback Method to calculate the payback period using 20% as the discounting factor

Year Cash Flow Discounting Factor at 20% Discounted Cash Flow (DCF) Cumulative DCF 0 -300000 1 -300000.00 -300000.00 1 88120 0.833 73433.33 -226566.67 2 88120 0.694 61194.44 -165372.22 3 88120 0.579 50995.37 -114376.85 4 88120 0.482 42496.14 -71880.71 5 88120 0.402 35413.45 -36467.26 6 88120 0.335 29511.21 -6956.05 7 88120 0.279 24592.67 17636.63 8 88120 0.233 20493.90 38130.52 9 88120 0.194 17078.25 55208.77 10 88120 0.162 14231.87 69440.64

From the table above, we see that the discounted payback period is = 6 yrs + (|-6956.05| / 24592.67)

= 6.283 years.

b. If the minimum after tax rate of return of 30% is required:

Let the room rent be a.

Revenue = RM (210 x 12 x a) = RM 2520x per year

Profit before Tax = RM (2520x - 80,000 - 10,000) = RM (2520x - 90,000)

Profit after Tax = (RM 2520x - 90,000)(1-0.3) = RM (1764x - 63,000)

Cash Inflows = RM(1764x - 63,000) = RM 10,000 (Depreciation) = RM(1764x - 53,000)

We now use the rte of return of 30% as the dicounting factor.  

The discounting factor for 10 years = 3.0915 (sum for each factor for 10 years, i.e. 0.769+0.592+...+0.073)

We can use the sum of discounting factors since our cash inflows over the 10 year period are even, i.e. the same year on year. This cannot be used in the cash inflows differ year on year, in which case the factor for each year would have to be applied.

Now, based on our requirement:

(1764x - 53,000) x 3.0915 = 300,000

We equate the inflows discounted by our required rate of return to our outflow of RM 300,000 as this will calculate the minimum room rate to achieve exactly 30% return.  

Therefore, solving the equation,

1764x = (300,000/3.0915) +53,000

x = 85.057.  

This means that the room rate should be RM 85.057 per day.