# Financial Issues in Tourism and Hospitality Questions

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Explanation & Answer length: 4 Question.

Homework 5 (20 points) Due: April 22 Q1. Dinah, the operator of Dinah’s Diner, wishes to choose between two alternative investments providing the following annual net cash inflows over the five-year investment period: a. Calculate the paypack time for each alternative, assuming initial investment of $33,000 under each alternative. (2 points) b. Using NPV at 12 percent, would either of them be a good investment for Dinah? (2 points) Q2. A restaurant operator wishes to choose between two alternative roll-in storage units. Machine A will cost $9,000 and have a trade-in value at the end of its five-year life of $1,500. Machine B will cost $8,500 and at the end of its five-year life will have a trade-in value of $700. Assume straight-line depreciation. Investment in the machine will mean that a part-time kitchen worker will not be required, and there will be an annual wage saving of $9,600. The following will be the operating costs, excluding depreciation, for each machine, for each of the five years. Income tax rate is 30 percent. For each machine, calculate the NPV by using a 12 percent rate. Ignoring any other considerations, which machine would be the preferable investment? (6 points) Q3. A hotel manager wishes to choose between two alternative investments giving the following annual net cash inflows over a five-year period: The amount of the investment under either alternative will be $70,000. a. Using the payback period method, in which year, under both alternatives, will she have recovered the initial investment? (2 points) b. Using NPV at 10 percent, would either alternative be a good investment? (3 points) Q4. Pete’s Pizza is planning to purchase a new type of oven that cooks pizza much faster than the conventional oven now used. The new oven is estimated to cost $20,000 (use straight-line depreciation) and will have a five-year life, after which it will be traded in for $4,000. Pete has calculated that the new oven will allow him to increase his sales by $30,000 a year. His food cost is 30 percent, labor cost is 40 percent, and other costs are 10 percent of sales revenue. Tax rate is 40 percent. For any new investment, Pete wants a minimum 12 percent return. Use IRR to help him decide if he should purchase the new oven. (5 points) Financial Planning and Growth: Capital Budgeting and Investment Decision THM2313 1 Importance of Growth • Firms need to grow • Growth can be expressed in various ways: – Assets in $ (the standard definition) – Revenue/Sales – Number of stores – Number of employees, etc. 2 Growth & Financial Manager • The role of financial manager is to support growth by making decisions on: – Dividend policy • How much of earnings they would re-invest into the business or pay dividends? – Capital budgeting • How much of assets we need more? – Capital structure • How to finance the additional assets? 3 Financial Planning • Primary activity of the firm is sales (operation). • Operating budget gives a clear picture about how future growth (net income) will be achieved. – Through sales (operating) activities • However, little is known about the firm’s other activities that support operating activities. • Capital budget details out the firm’s activities in two supporting areas: investing and financing – The goal is to support the firm’s sales growth 4 Capital Budgeting Decisions • To meet government requirements – e.g., Occupational Safety & Health Administration • To acquire equipment to reduce the operation’s costs. – e.g., substituting leased equipment to purchased one • To acquire property and equipment to increase sales – e.g., expanding a dining facility from 75 to 150 seats. • To replace existing equipment 5 Cash Flow in Capital Budgeting • Does the investment justify the expenditure? • Incremental Cash Flow – the change in cash flow of the operation resulting from the investment • Cash Flow relating to an investment ✓ Investment initial cost (cash outflow) ✓ Investment revenues (cash inflow) ✓ Investment expenses except depreciation (cash outflow) 6 Cash Flow Calculation Year 2 $25,000 1 $25,000 Revenues Expenses except for depreciation and income taxes Income taxes Cash flow 10,000 2,720(1) $12,280 10,000 2,720(1) $12,280 Net cash flow is determined as follows: Cash flows from above $12,280 x 3 = $36,840 Cost of machines 21,000 Net Cash Flow $15,840 (1) Income taxes: Pre-depreciation income Less: depreciation Taxable income Taxable rate Income taxes (2) Annual depreciation = Life 10,000 2,720(1) $12,280 Cost of machines $21,000 Life of machines 3 years Tax rate 34% Salvage value of machines 0 Annual Revenues $25,000 Related annual expenses including depreciation and income taxes $10,000 Method of depreciation Straight-line $15,000 7,000(2) 8,000 x .34 $2,720 Cost – Salvage Value 3 $25,000 = $21,000 – 0 3 = $7,000 7 Capital Investment Decisions • Accounting Rate of Return Net annual saving (Income) ✓ ARR = Average Investment ✓ The annual saving = the total project income over its life divided by the number of years ✓ Average investment is the initial investment plus trade-in value divided by two • The proposed investment is accepted if ARR exceeds the minimum ARR required/desired • Simple • Fail to consider cash flows and the time value of money Ex) [($700 + 1,260 + 896 + 2,044 + 2,100)/5] / $3,000 = 46.7% 8 Capital Investment Decisions 9 Capital Investment Decisions Page 501 10 Capital Investment Decisions • Payback Period When annual cash flows are equal Initial Investment Payback Period = Annual Cash Savings • Compares annual cash flows to the project cost to determine a payback period • Payback period equals the number of years it takes for cash flows to equal to project cost. • Reasonably popular in the Hospitality industry b/c of its simplicity. • Used as a screening device in conjunction with more sophisticated models. 11 Capital Investment Decisions Comparison of Two Mutually Exclusive Projects – Payback Model Years Hence 0 (cost of the projects) 1 (cash inflows) 2 3 4 5 Project Cash Flows Project A Project B $10,000 $10,000 5,000 4,000 3,000 2,000 1,000 2.33 years Payback Period Excess Cash Flow: Cash flow generated beyond payback period $5,000 Present value of all cash inflows discounted at 15% $10,986 3,000 4,000 5,000 6,000 7,000 2.60 years $15,000 $15,833 12 Time Value of Money “100 today is worth more than $100 a year from now” • The future value of a present amount Principal + (Principal x Time x Interest Rate) = total 100 + (100 x 1 x .12) = $112 F = P (1 + i)n Where F = Future value P = Present Amount i = Interest Rate n = Number of Years (or Interest Periods) Two hundred dollars invested at 10 percent for four years will yield $292.82, determined as follows: F = 200 (1 + .10)4 = 200 (1.4641) = $292.82 13 Time Value of Money ◼ ◼ The present value of a future amount (Discounting) Discounting is simply the reverse of compounding interest. P = F Where P F i n = = = = 1 (1 + i)n Present Amount Future Amount Interest Rate Number of Years The present value of $292.82 four years hence (assuming an interest rate of 10 percent) is $200 determined as follows: 1 P = 292.82 (1 + .10)4 = 292.82 (1 / 1.4641) = 292.82 x 0.6830 = $200 14 Time Value of Money • Annuity – a stream of receipts for several years at the same amount and at equal intervals. Years in Future (15% Discount) Present Value Amount $8,696 7,561 6,675 5,718 4,972 Total $33,522 1 $10,000 2 $10,000 3 $10,000 4 $10,000 5 $10,000 .8696 .7561 .6675 .5718 .4972 .8696 + .7561 + .6575 + .5718 + .4972 = 3.3522 15 16 17 18 Present Value of a Steam of Unequal Receipts Problem: Determine the present value of receipts from an investment using a 15 percent discount factor which provides the following stream of income. Years Hence Amount 0 $10,000 1 $10,000 2 $15,000 Solution: Years Hence 0 1 2 Amount $10,000 $10,000 $10,000 Excess of Annuity $0 $0 $5,000 Calculation: Present value of amount due today Present Value of the $10,000 annuity for 5 years $10,000 x 3.3522 Present Value of $5,000 due 2 years hence $5,000 x .7561 Present Value of $10,000 due 4 years hence $10,000 x .5718 Total 3 $10,000 4 $20,000 5 $10,000 3 $10,000 $0 4 $10,000 $10,000 5 $10,000 $0 = $10,000 = 33,522 = 3,781 = 5,718 $53,021 19 Capital Investment Decisions • Net Present Value (NPV) ✓ Discounts cash flows to their present value ✓ Accepted if the NPV is equal to or greater than zero Year Hence 0 1 2 3 4 5 Illustration of NPV (Single Project) Cash P.V. Present Value Flow Factor (15%) of Cash Flow $(50,000) 18,500 26,000 27,500 31,500 35,500 1.0000 .8696 .7561 .6575 .5718 .4972 Net Present Value $(50,000) 16,088 19,659 18,081 18,012 17,651 $39,491 20 Capital Investment Decisions • Net Present Value (NPV) – Multi projects 21 Capital Investment Decisions • Net Present Value (NPV) – Multi projects 22 Capital Investment Decisions • Net Present Value (NPV) – Multi projects 23 Capital Investment Decisions • Internal Rate of Return (IRR) ✓ Discounts cash flows to their present value ✓ In determining of IRR, the NPV of cash flows is set at zero and the discount rate is determined. ✓ A project is accepted if the IRR is equal to, or greater than, the established minimum IRR. 24 Capital Investment Decisions • Internal Rate of Return (IRR) ✓ For a project that costs $100,000 ✓ Cash inflows: a total of 115,000 (18,000 + 20,000 + 22,000 + 25,000 + 30,000) ✓ Salvage value: $10,000 25 Comparison of NPV and IRR Models • Which is preferred, NPV or IRR? ✓ NPV and IRR models are preferred to the ARR and Payback models. ✓ In most situations provide the same solution. ✓ NPV could suggest one project while the IRR model suggests a different project. ✓ NPV model is more useful when mutually exclusive projects are considered. 26 Mutually Exclusive Projects with Different Lives Cash Flow Years Hence 0 1 2 3 4 5 6 7 8 9 10 Alternative A Machine A (1) $(15,000) 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 Alternative B Machine B (2) Machine C (3) $(6,000) 3,000 3,000 3,000 3,000 3,000 $(11,000) 3,000 3,000 3,000 3,000 3,000 NPV – Alternative A NPV – Alternative B NPV = $3,000 (5.0188) – $15,000 NPV = $3,000 (5.0188) – $6,000 – 11,000 (.4972) NPV = $56 NPV = $3,587 27 Comparison of NPV and IRR Models 28 Choosing to Lease or Buy • Should a business lease or buy property? – Elements to Consider ✓ The effect of the decision on taxes ✓ Operating Leases (service leases) ✓ The Time Value of Money Assumption: The purchase cost of the van: $20,000 The annual lease payments: $5,000 for the first payment $4,565 (years 1 – 4) Simple Calculation: Total lease payments $23,260 ($5,000 + ($4,565 x 4)) ($3,260 more) Considering the Time Value of Money: Present value of first payment $5,000 Present value of next four payments: $4,565 (PVA n=4,k=12) = $4,565(3.0373*) 13,865 Total $18,865 Discounted Cash Flow Payments Considering Tax Effects and Salvage Value Assumption: 1) Marginal tax rate: 34%, 2) Discount rate: 12% 3) Method of depreciation: straight-line Time 0 1 Purchase $20,000 Salvage Value (1) Depreciation Tax Shield (2,3) 0 -$1,224 Net Purchase Cost Cash Flows 2 3 -$1,224 -$1,224 Discounted Cash Flows 4 -$1,224 Lease (4) $5,000 $4,565 $4,565 $4,565 $4,565 Lease Tax Shield (5,6,7) -$1,700 -$1,552 -$1,552 -$1,552 Net Lease Cost Difference: apparent advantage to leasing 1) $2,000 (PV n=5,k=12) = $2,000 (.5674) = $1,135 2) Depreciation expense x marginal tax rate = depreciation tax shield Depreciation expense: $20,000 – $2,000 = $3,600 5 $3,600 (.34) = $1,224 5 -$2,000 -$1,224 –$1,552 $20,000 – 1,135 -4,412 $14,453 $18,865 -5,727 $13,138 $1,315 3) $1,224 (PVA n=5,k=12) = $1,224(3.6048) = $4,412 4) $5,000 + $4,565 (PVA n=4,k=12) = $5,000 + $4,565 (3.0373) = $18,865 5) $5,000 (.34) = $1,700 6) $4,565 (.34) = $1,552 7) $1,700 (.8929) + $1,552 (2.7119) =$5,727 30 Discounted Cash Flow Payments for Financing the Van Purchase Time Purchase Down Payment Loan Payments (1) Interest Tax Shield (2) Depreciation Tax Shield (3) Salvage Value (4) Net Purchase Cost 0 Cash Flows 2 3 1 Discounted Cash Flows 4 5 $5,000 $4,939 $4,939 $4,939 -$612 -$439 -$340 -$1,224 -$1,224 -$1,224 1) Present Value of loan payments: $4,939 -$180 -$1,224 -0-0-$1,224 $2,000 $5,000 15,000 -1,252 -4,412 -1,135 $13,201 $4,939 x 3.0373 = $15,000 2) Interest tax shield: Year 1 2 3 4 Interest $1,800 1,423 1,001 529 Marginal x Tax Rate .34 .34 .34 .34 Interest Tax Shield $612 439 340 180 3) $1,224 (PVA n=5,k=12) = $1,224(3.6048) = $4,412 4) $2,000 (PV n=5,k=12) = $2,000(.5674) = $1,135 Discount Factors Discounted Interest @12% Tax Shield .8929 $546 .7972 350 .7118 242 .6355 114 Total $1,252 31 To Own or To Lease • Should a business lease or buy property? – Elements to Consider ✓ The effect of the decision on taxes ✓ Operating Leases (service leases) ✓ The Time Value of Money Assumption: The purchase cost of the furniture: $125,000 Tax rate: 30% To purchase Bank loan at 8% interest rate For year equal installment of (31,250) Will be depreciated over five years ($25,000/year) To lease Annual lease payments: $30,000 for five years (25,000 more) 32 33 34 35 36 37 38 39 40 41

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