Project Valuation II: Less Simple Hotel

Projects

$($I need help with the spreadsheet in excel$)$

Spiral Galaxy Hotels is considering two different ways to develop a property they bought for

$$6\mathrm{.}8$million last year. The local hotel market sales are $$250$million annually, and they hope to

get $25\%$of the market if they build a large hotel for $$75$million$.$ Alternatively, they could build a

smaller, upscale hotel that would only capture $20\%$of the market for $$40$million$.$ The large

hotel would have variable costs that are $30\%$of revenue while the upscale variable costs would

be $35\%$of revenue. The fixed costs are higher for the large hotel at $$8$million$/$year than the

upscale hotel at $$3\mathrm{.}5$million$/$year$.$The large hotel requires additional net working capital of

$$1\mathrm{.}5$million while the upscale hotel requires $$0\mathrm{.}9$million$.$ Both hotels will be depreciated to

zero under the rules for nonresidential real property in MACRS, and after $15$years the large

hotel can be sold for $$12\mathrm{.}5$million and the small hotel for $$9\mathrm{.}25$million; the land could be sold

for $$7\mathrm{.}5$million$.$ The tax rate is $23\%$for both projects.

In order to finance their investment, Spiral Galaxy Hotels will sell $1\mathrm{.}3$million shares to investors

at $$29\mathrm{.}43/$share$,$and they will borrow any additional funds they need. If they build the large

hotel, creditors will charge $7\mathrm{.}75\%$annually on their debt, but they will only charge $4\mathrm{.}25\%$on

debt for the small hotel. Since the large hotel is a bigger venture that will use more debt, the

firm$$s equity will be considered to be $2\mathrm{.}5$times as risky as investing in publicly traded stocks

$($which we expect to produce $11\%/$year; the risk$-$free rate is $1\mathrm{.}8\%).$The small hotel, on the other

hand, will result in equity that is only $1\mathrm{.}5$times as risky.

For the large hotel, there is a $15\%$chance that the hotel will not do well, and as a result

revenues will be only $50\%$of the expected. There is a $10\%$that the hotel will outperform

expectations and be a huge success, resulting in revenues that are $150\%$of expectations. For

the small hotel, the chance of failure is higher, at $30\%,$but a great success also has a higher

chance of $30\%.$Assume the same changes in revenue for the small hotel.

Determine what the value of each project is and which is preferable.

Homework:

If either hotel does poorly, we have the option to shut it down early; assume we will make that decision at the end of year three. In this case, we will assume that we can sell the hotel for $90\%$of book value and the land for $100\%$of book value.

On the other hand, if either hotel is a large success, we could invest more and expand; we will decide whether to expand after year three, invest during year four, and see changes from year five on$.$Assume there will be an available lot next door for sale for $$5$million$,$ we will spend $50\%$of our original construction budget to expand, and that we will finance at the same weighted$-$average cost of capital. The expansion will also require $40\%$more net working capital to be invested. The expansion project is expected to increase revenues by $55\%$and increase fixed costs by $30\%.$The new construction will also be depreciated in the asset class as the

original, but assume that the entire project can be sold after the fifteen years as before, and that the sales price will be $50\%$higher than without the expansion.

What effect does having abandonment and expansion options have on the two projects$$values$?$