Question

Number D E F H J Case Study #3 A hotel leases out it 1,000 square-foot coffee shop, although it continues to own the equipment. The lease is due for renewal. The hotel could continue to rent the space for $2 a square-foot per month for the next three years, and then $2.50 a square foot for the following two years. Alternatively, the hotel could cancel this lease and take over the operation of the restaurant. If this occurs, the hotel's management estimates that sales revenue in the first year would be $700,000 and that it would increase by $50,000 per year for each of the following four years. Variable operating costs of running the restaurant (food cost, wages, supplies) would be 90% of sales revenue. The hotel would also have to assume certain other costs currently paid by the lessee for such items as supervision, advertising and electricity. These are estimated to be $32,000 in year 1, increasing by $2,000 per year for each of the following four years. If the hotel resumes operation of the restaurant, it will trade in some of the old equipment, for which it will get $5,000 and buy $40,000 of new equipment (this will not happen if the lease is renewed). The new equipment will have a five-year life and would be depreciated on a straight-line basis with no scrap value. The hotel is in a 25% tax bracket. Should the hotel zperate the coffee shop itself or continue to lease it out. Use a 10% discount rate. heet1 Sheet2 Sheet3 +

Answer 1

Answer

Calculation of Net Cash Flow if the hotel operates Coffee Shop itself Year1 Year2 Year3 Year4 Year5 Sales Revenue (a) 700,000 $ 750,000 $ 800,000 $ 850,000 $ 900,000 =700000+50000 = 750000+50000 =800000+50000 =850000+50000 Variable Cost (a*90% =b) 630,000 $ 675,000 $ 720,000 $ 765,000 $ 810,000 Supervision Advertising & Leasing cost (c) Incremental Depreciation on Equipment (d) Net income (e =a-b-c-d) Less Tax @25% (e*25% =f) Income After Tax (e-f=h) Add incremental Depreciation on equipment (9) Net Cashflow after tax' (h-9) Pv Factor @10% Present value of net cash flow $ 32,000 $ $ 7,000 $ $ 31,000 $ $ 7,750 $ $ 23,250 $ $ 7,000$ $ 16,250 $ 0.909090909 $ 14,773 $ 34,000 $ 7,000 $ 34,000 $ 8,500 $ 25,500 $ 7,000$ 18,500 $ 0.826446281 15,289 $ 36,000 $ 7,000 $ 37,000 $ 9,250 $ 27,750 $ 7,000 $ 20,750 $ 0.751314801 15,590$ 38,000 $ 7,000 $ 40,000 $ 10,000 $ 30,000 $ 7,000 $ 23,000 $ 0.683013455 15,709 $ 40,000 7,000 43,000 10,750 32,250 7,000 25,250 0.620921323 15,678 Total Present value of cash flow if Hotel resume its operation $ 77,039.34 Calculation of Deprecistion on Equipment New Equipment Cost Less Trade cost for old equipment $ $ $ $ 40,000 5,000 35,000 7,000 = 35000/5 Deprecaition cost for 5 Year Note - It is assumed that on Asset with Cost of $ 5000, tax benefit effect is available in both the options. So depreciation is calculated on the incermental value of equipment purchased.

Calculation of cashflow if Hotel is leased out Hotel Space Rent Per Sq ft 1000 Sq Ft $ 2.00 per month Year1 $ Year2 2.00$ Year3 2.00 $ Year4 2.00 $ Year: 2.50 $ Rent per Month 2.50 Total Rent Pv Factor @ 10% Present value of net cash flow $ 24,000 $ 24,000 $ 24,000 $ 30,000 $ 30,000 =2*12*1000 =2*12*1000 =2*12*1000 =2.5*12*1000 =2.5*12*1000 0.909090909 0.826446281 0.751314801 0.683013455 0.620921323 $ 21,818.18$ 19,834.71 $ 18,031.56 $ 20,490.40 $ 18,627.64 Total Present value of cash flow if Hotel is leased out $ 98,802.49 Present cash flow is more in leasing option as compare to resuming the hotel operation. So hotel should be leased out

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