Big Investment in Small Hotel
Is it a good investment? If so why? What can change the investment from a good one to a bad one?
There are different methods by which an investment can be evaluated. The method of choice would usually be the comparison of the Net Present Values of two investment opportunities as only the Net Present Values take into account the time value of money, the cash flow and cost of capital. Furthermore, the Net Present Value shows potential investors when they will be able to recuperate their investment. It also shows how much value is created or destroyed as a result of undertaking a project. Finally, the Net Present Value measures the attractiveness of a project in today’s pounds. This means that several projects can be combined. If a choice is given between two investment opportunities, the investment with the larger Net Present Value should be chosen.
Another method of calculating the merits of a project is the Internal Rate of Return. The Internal Rate of Return is useful because it is easy to calculate and it only depends on the cash flow of the particular investment project. On the other hand, the Internal Rate of Return only gives a percentage and no absolute value.
Judging from the values of the calculation, it is fair to say that the investment in the hotel room is preferable to the investment in the savings account:
Investment in the Savings Account
The Net Present Value of the Investment is exactly zero (if taxes are not taken into account). This makes perfect sense, as the discount rate of the future value equals the interest rate of the investment. Both rates are equal because the money is invested in a mutually risk free environment. Therefore there are neither gains nor losses if the money is invested in the savings account.
This also means, that the Internal Rate of Return is equal to 5 %. (The calculations for the investment in the hotel room can be seen on sheet “Investment Savings Account” in the Excel file.)
However if a tax rate of 30 % is applied to the interest gained in the investment, a negative Net Present Value is achieved (-3,890.35 GBP), as the actual net benefit of the investment will be less than the discount rate. The Internal Rate of Returns in this case only amounts to 3.55 %. (The effect of the income tax can be seen on sheet “Assumptions” in the Excel file.)
Investment in the hotel room
The investment in the hotel room would give Ben James a Net Present Value of 40,923.38 GBP and an Internal Rate of Return of 12 % (without taking the tax rate into account). If a tax rate of 30 % would be applied, this would effect our Net Present Value (21,969.98 GBP) as well as the Internal Rate of Return (6.35%), as can also been seen on sheet “assumptions” in the excel file.
However, the model as shown in the appendix is based upon a number of crucial assumptions without which the whole nature of the investment might turn from good into bad.
Occupancy rate: 85 %
The calculation uses an occupancy rate of 85 %. This number is justified by the increasing demand in hotel rooms in the past three years prior to the investment opportunity.
Rent for the room: 130.00 GBP per day
According to the data, more hotel rooms will become available, whereas at the same time the data suggests an increase in the demand of hotel rooms in London. Based on the assumption that the economic conditions in the U.S. remain stable. The data provided shows which hotel categories will be built
Management Cost: 40 % of the revenues
The management costs resemble the variable costs and have been estimated at 40 % without any further justification.
Annual Savings for Renovation: 1,000 GBP per annum
The annual savings for renovation expenses resemble fixed costs. The fixed costs seem relatively low. However, in the case of any unforeseen events, such as flooding or fire, all hotel room...
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