Hospitality Industry Applications of Time Value of Money Concepts and Skills

Chapter 9Hospitality Industry Applicationsof Time Value of MoneyConcepts and SkillsCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedChapter OverviewQuestions to consider when Securing a LoanQuestions to consider when Raising EquitySensitivity AnalysisCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedLoan ComponentsPrincipalAmount of money being borrowedDebt ServiceFixed payments to the bankInterest RatePercentage of loan balanceAmortization RateNumber of years debt service payment is based onCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedPrincipal AmountThe amount of principal the bank will lend is based on:Cash flow projectionsPresent value of the businessLoan-to-value ratio (LTV)Loan-to-cost ratio (LTC)Debt service coverage ratio (DSCR)DSCR = Cash Flow / Debt ServiceCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedHow much can be borrowed?Principal amount is based on:The amount of money dedicated to debt serviceLender’s termsAmortization rateInterest rateLTVCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedPrincipal Amount CalculationPMTAmount the borrower is comfortable committing to debt serviceNLender’s amortization rateI/YLender’s interest rateCPT PVCompute for the loan amountCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedWhat is the maximuminterest rate?Interest rate calculation:PVAmount of the loan determined by the borrower’s needsPMTAnnual debt service payments borrower is comfortable payingNLender’s amortization rateCPT I/YInterest rate borrower needs to negotiate with the lenderCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedWhat is the maximumamortization rate?Amortization rate calculation:PVAmount of the loan determined by the borrower’s needsPMTAnnual debt service payments borrower is comfortable payingI/YInterest rate offered by the lenderCPT NSolve for the amortization rate the borrower should negotiate with the lenderCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedDebt Service PaymentsForm of annuityAn even stream of cash flow for a number of periodsCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedDebt Service Payment CalculationPVLoan amount determined by the borrowerI/YInterest rate offered by the lenderNAmortization rate offered by the lenderCPT PMTCalculate the debt service paymentCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedHow much equity canthe borrower raise?Function of the deal’s:Cash flow projectionsEquity investor’s hurdle rateCalculate the NPV of the deal utilizing the investor’s hurdle rate as the discount rateIRR of the deal must be higher than the hurdle rateCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedEquity Analysis Example |----------|----------|----------|----------|----------| 0 1 2 3 4 5 Years 50 100 300 305 320 -800Utilize [CF] button and enter:CF0 = -800CF1 = 50CF2 = 100CF3 = 300CF4 = 305CF5 = 320Investor’s Hurdle Rate = 10%CPT IRR = 8.5%CPT NPV = -$39.49Investor will not accept the deal.Copyright © 2007 by John Wiley & Sons, Inc. All rights reservedOwnershipWhen the IRR is higher than the investor’s hurdle rate, the deal sponsor can ask for:Carried InterestOwnership percentage with no equity investmentPromoted InterestOwnership awarded after equity investors achieve their hurdle rateEquity KickerPercentage of profit on sale of the assetCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedHow much ownership should be offered the equity investor?Calculation focuses on cash distributions to the investorCalculate the present value of all cash flows using the investor’s hurdle rateDivide the equity investment by the present value of future cash flows calculatedCost / PV = amount of ownership which should be offeredCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedSensitivity AnalysisMethod of analyzing investment opportunities by altering the assumptions on which the projections are basedChange key assumptions by +10% and -10%Objective is to calculate the deal’s upside and downside potentialCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedLoan Amortization ScheduleProvides information on the year, payment, principal, interest, and balance of a a loanDebt service payments remain fixedPrincipal repayment component increasesInterest component decreasesCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedLoan Amortization CalculationUsing a business calculator:Step 1: Perform the annuity calculation to determine the annual debt service paymentStep 2: Click on the AMORT functionStep 3: Calculator displays P1 and P2P1 stands for beginning of periodP2 stands for the end of the periodStep 4: Scroll through the worksheet and you will see principal, interest, and balanceCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedLoan Amortization ExampleUtilize the calculator to calculate the amortization schedule below.A restaurant would like to purchase new deep fat fryers for $40,000. The bank offers a five-year loan at an interest rate of 5.0%. Calculate debt service and prepare an amortization schedule. Year Payment Principal Interest Balance 1 36,955.97 28,955.97 8,000.00 131,044.03 2 36,955.97 30,403.77 6,552.20 100,640.26 3 36,955.97 31,923.95 5,032.02 68,716.31 4 36,955.97 33,520.15 3,435.82 35,196.16 5 36,955.97 35,196.16 1,759.81 0.00Copyright © 2007 by John Wiley & Sons, Inc. All rights reservedDetermining ValueThere are several ways to determine current market or appraised value.Cost ApproachSales ApproachIncome ApproachIRR ApproachCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedCost Approach to ValuePlaces value on the property based on the:Current value of the landCurrent cost to rebuild the physical structureCurrent cost to replace the existing furniture, fixtures, and equipmentCost required to replace the property as isPhysical deterioration or functional obsolescence is included in the analysisCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedCost Approach FormulaEstimated Additions +Land $250,000 +All improvements (if new) 500,000 +Furniture, fixtures, and equipment 200,000Estimated Deductions (depreciation) -Physical (50,000) -Functional (75,000) -Economic (85,000)=Value of the Hotel $740,000Copyright © 2007 by John Wiley & Sons, Inc. All rights reservedSales Approach to ValueValues a property based on recent comparable salesSelling prices of properties of similar size, quality, and market are used to estimate valueCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedSales Approach ExampleComparable sales for the International Airport HotelToday’s date: November 30, 2008Sale date of other full-service hotels:Hotel Orion January 18, 2008Moon River March 24, 2005Blue Marlin June 22, 2000Sale date of hotels of comparable competitive markets and attributes:Jade Garden March 13, 2008 (full-service airport hotel)The Esmeralda April 4, 2008 (full-service same clientele)The sale price of the above hotels will be averaged and adjusted to derive a price for the International Airport Hotel.Copyright © 2007 by John Wiley & Sons, Inc. All rights reservedIncome Approach to ValueEstimates future cash flows including an assumed sale at the end of the analysis periodDiscounts cash flows using WACCPV is the appraiser’s estimate of current market valuePreferred by most appraisers, buyers, and sellersTakes into consideration the future income potentialCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedIRR Approach to ValueUsed to determine if the asking price yields an IRR that is equal to or exceeds the equity investor’s hurdle rateDone by inputting the asking price as the cost in year 0 and inputting each year’s cash flow including the assumed saleCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedLease vs. Purchase DecisionDetermine if the present value of lease payments is less than the purchase optionI/YCost of capital if you were to purchase the assetPMTAnnual lease paymentNNumber of years of the leaseCPT PVPresent value of the lease paymentsCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedAnalysis of Multiple InvestmentsReturn on Investment (ROI)ROI = cash flow / equity investmentAdvantageEasy to calculateDisadvantagesDoes not take into consideration the:Time value of moneyPotential sales value of the assetCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedAnalysis of Multiple InvestmentsPV and NPVThe investment is favorable as long as the PV is greater than the costAdvantagesTakes into consideration the:Time value of moneyPotential sales value of the assetDisadvantageCannot compare investments with varying costsCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedAnalysis of Multiple InvestmentsInternal Rate of Return (IRR)AdvantagesTakes into consideration the:Time value of moneyPotential sales value of the assetAllows you to compare investments requiring varying amounts of capitalDisadvantagesAssumes that cash distributions are reinvested at the IRR rateIf a negative cash flow is projected, there is a possibility for multiple IRRs to be computedCopyright © 2007 by John Wiley & Sons, Inc. All rights reserved