Question

I am thinking about going into the hotel business through acquiring 12 hotels spread throughout the Rocky Mountain region. I have projected out the costs of hiring managers to run the hotels, as well as the other many costs of operating them. Based on this, I have a good handle on the cash flows the project will generate, and I now need to estimate the cost of equity I will use to discount these cash flows.

Unfortunately, I am out of time, and so I need you, my brilliant financial protege, to give me an estimate of a reasonable cost of equity for this project. Obviously, I don't have the 10 million needed to acquire the hotels myself and will need to attract additional equity financing from outside investors. So when I meet with these investors, I need a logical estimate and explanation for what the cost of equity is that they should be earning. So don't just give me a number, you have to tell me why you pick what you do.

Obviously, they could invest in many other hotel chains and management companies, many of which are publicly traded. So your best approach is to look at the cost of equity for these pure-plays (the ticker for Hilton is HLT, but I would rely on estimates from more than one company so look up their competitors) and make adjustments based on our situation. For instance, consider the following differences:

Are your pure-play firms more or less risky based on geographic dispersion relative to us?

Are your pure-play firms more or less risky based on easier access to additional capital?

Am I or these pure-plays more likely to achieve operating efficiency (higher profit margins) over the next four or five years?

There are certainly other considerations you might come up with that I am missing right now, so feel free to include them as well. But make adjustments to your estimates to fit my situation. Then write up your conclusions in a professional sounding report that is no longer than one page. Put any additional tables in an appendix.

(The 12 hotels are not relevant. They only give you the industry that you are researching. If you want to value a company, you have to figure out what companies in that same industry are selling for, or what kind of discount rate investors expect for firms in that industry. So you have to look at other firms in the same industry. So you will look up hotel firms, and calculate their cost of equity. And then you will make adjustments to their costs based on the subject firm with 12 hotels. So think about this logically. Would you rather invest in Hilton, with thousands of hotels, or this company with 12? Which is less risky? Which has more growth potential? These are the kinds of issues you would think about when estimating the cost of equity using the pure play approach. But no, this is not based on an actual firm, so there won't be stuff on the internet about it. )

Answer 1

First, we calculate the cost of equity of companies in the same industry.

Cost of equity is estimated as (D₁ / P₀) + g,

where P₀ = current share price

g = constant growth rate

D₁ = expected dividend next year

Hilton :

P₀ = $97.21

D₁ =  $0.60

g = 16.55%

Cost of equity = ($0.60 / $97.21) + 16.55% = 17.17%

Marriott :

P₀ = $140.27

D₁ =  $1.71

g = 6.90%

Cost of equity = ($1.71 / $140.27) + 6.90% = 8.12%

Wyndham :

P₀ = $56.73

D₁ =  $1.16

g = 11.40%

Cost of equity = ($1.16 / $56.73) + 11.40% = 13.44%

Average cost of equity for industry = (17.17% + 8.12% + 13.44%) / 3 = 12.91%

Now, we adjust the industry average cost of equity for these factors :

• Are your pure-play firms more or less risky based on geographic dispersion relative to us?
  • The pure-play firms are widely distributed geographically all over the country. Hence, they are less risky as revenue is not concentrated geographically in any region.
  • As we are more risky than the geographically diversified companies, we add 2% to the industry cost of equity
• Are your pure-play firms more or less risky based on easier access to additional capital?
  • The pure-play firms are publicly traded and well known, which makes it easier for them to raise additional capital.
  • As we are more risky than these companies (since they have much easier access to additional capital), we add 1.5% to the industry cost of equity
• Am I or these pure-plays more likely to achieve operating efficiency (higher profit margins) over the next four or five years?
  • The pure-play firms have been in this business for a very long time, and they have the skills and knowledge and experience to achieve higher profit margins.  
  • As we are more risky based on our likelihood of achieving operational efficiency, we add 1% to the industry cost of equity

Cost of equity for us = industry average cost of equity + 2% + 1.5% + 1% = 12.91% + 2% + 1.5% + 1% = 17.41%