Question

Alliston spa, a California company, has been expanding in the Northeast. It has opened a spa in Stowe, Vermont, and another in the Berkshires, Massachusetts, and is now planning to open a third one in the East End’s South Fork of Long Island, New York. Alliston is eyeing an unused space owned by Orange Shores Inn. The space is located on the third floor of the main building. About 1/5 of the 10,000 sq. ft. space will be used to build a wide pathway with a garden trellis along the path to connect the main building to a new addition under construction. The rest of the space can be rented out to a third party.  

Alliston spa has offered to lease the unused property with Orange Shores Inn for 4 years for a monthly rent of $22,000 for the first 2 years, and a 7% annual increase for the next two years

Orange spa has the following two options :.  

Alliston spa.   The Orange hotel has to make the space ready for lease. It has to set up the partitions and put in all the necessary plumbing and new flooring. The estimates for the up-front renovation costs range from $200,000 to $250,000 to be depreciated over the life of the project using straight-line with a zero salvage value. Any other spa-related installations will be assumed by Alliston. The existing elevators and toilets would be used by Alliston and, therefore, a pro-rata allocation of the costs of the facilities should be based on the area that will be used. It is estimated to be $11,000 per annum. In addition, there will be an allocation of $ 2,000 per annum to Alliston for any repair and maintenance costs that will be incurred. Alliston will pay all utilities and other operating expenses.   

             Orange Spa. If the hotel creates its own spa, the up-front investment is estimated to range between $200,000 to $230,000. Other capital investments will include the installations of whirlpools, sauna, and massage and facial rooms. These additional investments will amount to $150,000.    

            

Revenues are expected to be generated 30% from hotel guests and the other 70% from outside bookings. Total sales are estimated to be $845,000 the first year of operation. This revenue has been arrived based on expected hotel bookings per year and prediction of demand for spa services from Long Island and the surrounding area. There will also be a spill-over effect from outside spa guests patronizing its own restaurant, adding additional covers per day. It is estimated that this will generate additional revenues of $55,000 per annum.  

            

             The project is estimated to last for 6 years. Sales are expected to grow at 4% per year. Estimates of the operating costs are as follows:

             Salaries                                                                            15% of Sales

             Other operating expenses                                              30% of Sales

             Depreciation- equipment & furniture                          Straight-line; zero salve value

             Capital expenditure                                                        Equal annual depreciation

             Cost of Capital.    Orange Shores Inn has a capital structure consisting of 40% debt and 60% equity. The debt consists of loans from the Long Island Bank with an interest rate of 6.8%. The cost of equity of the hotel shareholders is 16%. The corporate tax rate is 40%.  

It is possible that the hotel will project a different image to the public if it offers spa services. Instead of a hotel that caters to families, it will be perceived more as a hotel that caters to couples and singles. This might have a negative impact in terms of attracting tourists traveling with children. The total patronage for the hotel might decline by 12%. Below is the projection on net room revenue for the next six years.

Projection of Net Room Revenue

(Room Sales – Room Operating Expenses)

Year	1	2	3	4	5	6
Net Room Revenue	$2,200,000	$2,400,000	$2,500,000	$2,600,000	$2,650,000	$2,700,000

1. What are the relevant cash flows associated with each project?
2. How should the different lives of the projects be accounted?
3. What criteria should be used to evaluate the projects?
4. Which project is recommended

Answer 1

This is the format to approach.

1. Find Cashflow
2. Appropriate Discount Rate
3. NPV and Compare
4. If Unequal lives, use EAA(Equivalent Annuity Approach). [Works always]
5. Compare and decide

You can also use Replacement Chain Analysis assuming everything remains same, but its cumbersome.

EAA:- You have PV(NPV), Rate (WACC) and nper(Years), you will have one annuity (PMT) that gives same npv at same rate with same number of years. Find it and compare, and you will have answer. Try to solve it using the format. You can also use the formulae I used. Please find them below.

Alliston Spa is recommended

All the Best