Question

Question 12

(a) A hotel has undergone renovations and is considering which revenue management software system to adopt. The system is meant to optimize the pricing and availability of the hotel’s rooms. The two market leading revenue management software systems are Opera by Oracle and RoomMaster by InnQuest and the hotel has to adopt one. Opera costs £1 million and will increase the operating profits by £500,000 per year. Its useful life is 5 years and it is estimated to have no salvage value after that due to the rapid rate of technological change. The RoomMaster system costs £1.5 million and is estimated to increase the operating profits by £700,000 per year for five years after which it will also have no salvage value. For tax purposes the hotel can depreciate either system linearly. The tax rate is 30% and the cost of capital is 13%. A piece of software, bought for £600,000 a year ago, is not suitable, as after the renovations the hotel has changed the scale of operations and the market segment targeted.

(a.1) Derive the net cash flow for the hotel each year both in case it adopts Opera and in case it goes for RoomMaster. Carefully discuss each component of the cash flow.

[7 Marks]

(a.2) Which is the most appropriate criterion for the choice faced by the hotel?

Explain.

[4 Marks]

(a.3) Apply the criterion selected in (a.2) and find which revenue management

system the hotel shall adopt.

[7 Marks]

(b) What is meant by “cost of capital” in the capital budgeting process of a firm? Explain how firms use it and how they try to compute its value.

[7 Marks]

Answer 1

(a.1)

It costs 1 million in the initial year. After that, for the next 5 years, it will earn 500,000. So, every year on that operating profit, there will be a tax expense. The tax rate is 30%. So, Net cash flow every year using Opera is

500,000 * (1 - 0.3) = 500,000 * 0.7 = 350,000

If they use RoomMaster they will earn 700,000 every year for the next 5 years. Then, after cutting the tax (30%) net cash flow will be = 700,000 *(1- 0.3) = 700,000 * 0.7 = 490,000

So, Net cash flow for Opera = 350,000/yr and for Room Master = 490,000 / yr

(a.2)

Most appropriate criteria to select the software system is "NPV Model". NPV or NET PRESENT VALUE shows the exact cash flows value at the present time when they invest their fund in the project. It considers the cost of capital. That includes the time value for money and return expected by the shareholders.

If the NPV value is positive, then they can invest the money there. For the case where they need to choose between two projects, they can choose the project with a higher positive value of NPV.   

(a.3)

Net Cash Flow for both the Softwares Shows below in the Pic

So, NPV for Opera = 231,030.94

Whereas NPV for Room Master,

As from the calculation, you can see NPV for Oracle Opera is greater than NPV for RoomMaster(Opera > RoomMaster), that's why they should choose Opera Revenue Management System for their hotel.

(b)

Cost of capital means the cost a company has to pay to the source of the fund.

Funds can come from different sources. Which is of 2 types,

• Equity
• Debt

From these two sources has 2 costs,

• Cost of Equity
• Cost of Debt.

If Cost of Equity is x and Cost of Debt is y, then