Question

Destination Hotels currently owns an older hotel on the best beachfront property on Hilton Head Island, and it is considering either remodeling the hotel or tearing it down and building a new convention hotel, but because they both would occupy the same physical location, the company can only do one—that is, these are mutually exclusive projects.

Both these projects have the same initial outlay of $1,000,000. The first project, since it is a remodel of an existing hotel, has an expected life of 8 years and will provide free cash flows of $250,000 at the end of each year for all 8 years. In addition, this project can be repeated at the end of 8 years at the same cost and with the same set of future cash flows. The proposed new convention hotel has an expected life of 16 years and will produce cash flows of $175,000 per year. The required rate of return on both of these projects is 10 percent. Calculate the NPV using replacement chains to compare these two projects.

Answer 1

First project with 8 years:

Particulars	First 8 years	Second 8 years	Total
Annual OCF	250,000.00
× annuity factor	5.33493
Present value of inflows	1,333,731.55
Less: investment	(1,000,000.00)
NPV first	333,732
NPV at beginning of 9 year		333,732
× PVF		0.46651
Present value	333,732	155,688.23	489,419.78

NPV for 16 years is 489,419.78

Second project with 16 years life:

Particulars	First 8 years
Annual OCF	175,000.00
× annuity factor	7.82371
Present value of inflows	1,369,149.01
Less: investment	(1,000,000.00)
NPV	369,149

NPV is 369,149

Take first project with 8 years and repeat it for another 8 years. It has highest NPV.