Sarah Adams manages Executive Inn of Toronto, a 200-room facility that rents furnished s...

Sarah Adams manages Executive Inn of Toronto, a 200-room facility that rents furnished suites to executives by the month. The market is for people relocating to Toronto and waiting for permanent housing. Adams’s compensation contains a fixed component and a bonus based on the net cash flows from operations. She seeks to maximize her compensation. Adams likes her job and has learned a lot, but she expects to be working for a financial institution within five years.

Adams’s occupancy rate is running at 98 percent, and she is considering a $10 million expansion of the present building to add more rental units. She has very good private knowledge of the future cash flows. In year 1, they will be $2 million and will decline $100,000 a year. The following table summarizes the expansion’s cash flows:

Based on the preceding data, Adams prepares a discounted cash flow analysis of the addition, which is contained in the following report:

The discount factors are based on a weighted-average cost of capital of 12 percent, which accurately reflects the inn’s non diversifiable risk.

Adams’s boss, Kathy Judson, manages the Inn Division of Comfort Inc., which has 15 properties located around North America including Executive Inn of Toronto. Judson does not have the detailed knowledge of the Toronto hotel/rental market as Adams does. Her general knowledge is not as detailed or as accurate as Adams’s. (For the following questions, ignore taxes.)

Required:

a. The Inn Division of Comfort Inc. has a very crude accounting system that does not assign the depreciation of particular inns to individual managers. As a result, Adams’s annual net cash flow statement is based on the operating revenues less operating expenses. Neither the cost of expansion nor depreciation on expanding her inn is charged to her operating statement. Given the facts provided so far, what decision do you expect her to make regarding building the $10 million addition? Explain why.

b. Adams prepares the following report for Judson to justify the expansion project.

Judson realizes that Adams’s projected cash flows are most likely optimistic, but she does not know how optimistic or even whether or not the project is a positive net present value project. She decides to change Adams’s performance measure used in computing her bonus. Adams’s compensation will be based on residual income (EVA). Judson also changes the accounting system to track asset expansion and depreciation on the expansion. Adams’s profits from operations will now be charged for straight-line depreciation of the expansion using a 10-year life (assume a zero salvage value). Calculate Adams’s expected residual income from the expansion for each of the next 10 years.

c. Based on your calculations in (b), will Adams propose the expansion project? Explain why.

d. Instead of using residual income as Adams’s performance measure in (b), Judson uses net cash flows from operations less straight-line depreciation. Will Adams seek to undertake the expansion? Explain why.

e. Reconcile any differences in your answers for (c) and (d).