The Hamptons Hotel and Restaurant: Mutually Exclusive Investments Property Description and Background Information
The Hampton Hotel is located in the Hamptons Road area of Virginia Beach, Virginia. The hotel is rated as a four diamond hotel, based on the United States hotel rating system. The hotel is considered as being unpretentious but luxurious. The Hamptons Hotel is approximately 7 years old. The hotel consists of 250 guestrooms made up of 50 premium rooms and 200 standard rooms. There is only one restaurant, capable of seating 150 persons. There is also a lobby bar which connects with the restaurant. The only entrance to the hotel is through the lobby bar. In addition, the hotel offers a full range of services to guests, including a large conference and event space for up to 200 persons, an exercise room overlooking the ocean, an outdoor pool and recreation area, free parking for guests, and room service. The average annual occupancy is 63%. The market segments include business, leisure, tour, contract, large groups, and small groups.
Three years ago, the Hamptons Hotel was acquired by Hilton International, a U.S. publicly traded corporation with holdings worldwide. It initially paid $31.5 million for The Hamptons Hotel and invested an additional $2.0 million in renovations and furnishings.
Although management has been highly successful in increasing hotel room occupancy and improving overall hotel revenue, the restaurant continues to be unprofitable even with increased food and beverage revenue. After undistributed operating expenses and fixed charges have been allocated to the restaurant, the restaurant continues to operate at a loss and is not capable of absorbing its share of overhead. Unfortunately, the hotel restaurant has followed a trend in the U. S. hotel industry which began in the 1980s and 1990s. Currently, the hotel restaurant only serves an average of 60% of hotel guests at breakfast and serves only 22% of hotel guests at dinner. Walk-ins from the outside account for the remaining customers.
The corporate financial manager and The Hamptons General Manager are at odds with what should happen with the restaurant in the future. The corporate financial manager argues that the restaurant should be closed and offered to a suitable chain restaurant group under a leasing arrangement. The general manager, however, is certain that if corporate could provide additional funding to construct an access to the restaurant from the street and make the restaurant trendier in style, then the hotel restaurant could show profitability in the future.
The corporate financial manager has already approached three reputable upscale chain restaurants. The restaurant chains have agreed to review the offer if Hilton agrees to construct an entrance with street access to the restaurant. The most feasible of the three is Ricks Steak and Seafood, a very popular upscale restaurant with locations in beachfront cities on the eastern coast of the U. S. The leasing agreement will be for five years and provides for $62,000 in lease income each year. Renewal of the lease will be at the option of Hilton. Therefore, the projections will be based on a five-year leasing period. The initial investment to provide street
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accessibility is estimated to cost $950,000 and should be depreciated over 20 years. Although Ricks Steak and Seafood will provide alcoholic and non-alcoholic beverages, Ricks has agreed not to operate a bar or lounge area for customers, but allow customers who are awaiting seating or wish to meet in the bar after dining to use the hotel lobby bar. The financial manager has estimated that this will increase the bar revenue of $12,500 for the first year and an additional increase of 5% per year for each year thereafter. Beverage costs amounts to approximately 20% of sales. The financial manager also realizes that not all of the overhead charged to the restaurant will be eliminated and that other hotel operated departments will have to absorb some of the overhead costs. His best estimate of the overhead that can be eliminated from the hotel is $200,000 per year. In addition, the financial manager estimates that there will be a one- time reduction in working capital required of approximately $70,000 as a result of lower accounts receivables and lower inventories. Although some portion of existing equipment will be included in the lease, the remaining equipment and furnishings will be sold at an estimated cash gain before taxes of $80,000 (the sale will occur in Year 1 of the lease). You can assume that future tax rates for Hilton will be the same as the last fiscal years effective tax rate.
The general manager discussed his proposal for renovation and construction of the street access with an architect. In the architects opinion, the cost to renovate the restaurant in an appropriate style and construct the street access would cost $1.8 million, also to be depreciated over 20 years. The general manager has based his projections on five years since corporate has made it clear that if the restaurant remains in-house, then the restaurant must be profitable over the next five years. The GM has also forecasted the increase in potential restaurant revenue of $800,000 for the first year, with an increase of 10% every year for the next four years. Cost of sales, including both food and beverage, amount to approximately 35% of sales. With the increase in sales, two additional waiters will probably have to be hired (you will have to determine the additional cost). The general manager has also included an additional investment in required working capital based on the increased sales, inventories, and purchases payable; you can assume NOWC to be 5% of revenue, so an increase in revenue should create a corresponding increase in NOWC. Although the restaurant will be renovated, some of the older equipment will remain. Therefore, additional cash reserves of $100,000 to $140,000 for the entire five year will be needed for future replacements in equipment (CAPEX reserves, annual amounts to be distributed at the discretion of the hotel). The general manager has applied an average tax rate of 25% to the projected operating cash flows.
For the calculations, both the corporate financial manager and the GM considered all the companys investments to have the same average risk as the Hilton Corporation. For income tax purposes, the original investment for either proposal will be depreciated using the straight- line method based on a five year life with no salvage value. The average tax rate for the group is also 25%.
Meeting with the Managers
You have been requested to consult Hilton and participate in the meeting in order to make a decision on which investment is the optimal choice, i.e., creates the most value for the
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shareholders. Before attending the meeting, you are requested to complete the analysis of the mutually exclusive investments. In preparation for the meeting, you will prepare a formal paper analyzing the two investments and responding to the following questions:
1. Calculation of corporation cost of capital and various profitability measures (40%)
Based on the cost of capital for Hilton and its average
asset risks for both proposals, estimate their cost of capital. Then, calculate each proposals payback period, annual return on investment, IRR and NPV. Which proposal creates more value? In presenting your results, provide justification as to why you have selected one proposal over the other. This will require a discussion of the pros and cons of the valuation methods presented in the proposal.
Knowledge and Understanding
2. Analysis of risk of the different alternatives (20%)
Even though it was considered that both proposals are in
the same risk category as their other investments, how would you assess each proposals risk? Justify your response. If you find necessary to reassess any of the proposals risk level, would that change your estimation as to which one creates more value?
Knowledge and Understanding
3. Change in risk levels and in the cost of capital (15%)
Assume that Hiltons beta increases by a multiple of 1.3
(i.e. it becomes 1.3 times the beta you originally calculated) and that its cost of debt go up by about 1.5%. What is the new cost of capital for Hilton? Does your response to Questions 1, 2 and 3 above change? Why or why not? What does this tell you about the proposals sensitivity to the cost of capital chosen? What could cause the beta and the cost of debt to increase?
Knowledge and Understanding
4. Analysis of uncertainties (20%)
Analyze the sources of uncertainties in the estimations (the managers and yours); how confident are you about the calculations? What, if any, additional information would you require to decrease the uncertainties involved in the proposals and to make a more informed decision as to the optimal investment opportunity? Justify your response.
Cognitive Skills Professional
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5. References and presentation (5%)
Your reference list should appear at the end of your paper. It provides the information necessary for a reader to locate and retrieve any source you cite in the body of the paper. Each source you cite in the paper must appear in your reference list; likewise, each entry in the reference list must be cited in your text. The report should be well-written, free of spelling and grammar mistakes.