Question

You purchased land 3 years ago for $60000 and believe its market value is now $90000. You are considering building a hotel on this land instead of selling it. To build the hotel, it will initially cost you $150000, an expense that you plan to depreciate straight line over the next three years. Wells Fargo offered you a loan for $60,000 at an 8% interest rate to be repaid over the next 4 years. You anticipate that the hotel will earn revenues of $165000 each year, while expenses will be a mere $30000 each year. The initial working capital requirement will be $7000 which will be recovered in the last year. The tax rate is 35%. Your estimated cost of capital is 10%. What is the net present value of this project?

Answer 1

(1) Initial Investment will include, market value of land, initial cost to build and initial working capital

= 90000 + 150000 + 7000

= 247000

(2) Annual cash flows

Sales Revenue	165000
(-) expenses	30000
Net Revenue	135000
(-) Depreciation	50000
Profit before tax	85000
(-) Tax	29750
Profit after tax	55250
(+) Depreciation	50000
Annual cash flow	105250

NOTE : Interest on loan or installments payable annually are irrelevant for computing NPV. Because we compute NPV for the firm i.e cost of capital is WACC and not cost of equity. So, interest is not considered in computing the above cashflows.

NPV = Preset value of annual cash flow + Present value of working capital recovery - Investment

= 105250 * [ 1 - (1.10 )^-3 ] / 0.10 + 7000 * (1.10)^-3 - 247000

= 261741 + 5259 - 247000

= 20,000 ................ is the NPV of the given project