Assessment of Financial Outcomes for Hospitality Investment Projects

Osman Cenk Demiroglu, Lecture Notes, Istanbul University, April 2005

Also see Sample Hotel Valuation

“Determining the feasibility of the investment decision by comparing its benefits (cash inflows) and costs (cash outflows)"

“Determining a project's consistency and solidity in terms of financing"

Objective: Optimization of the scarce resources through choosing the right option(s) among the investment alternatives

 
Data & Information Required for the Assessment of the Financial Outcomes for Hospitality Investment Projects

ü    Occupancy Rates (Market Research, Supply-Demand Analysis)

ü    Average Daily Rates (Marketing Policy, Pricing Strategy)

ü    Operational Analysis (Fixed & Variable Revenues & Expenses)

ü    Investment Cost (Land, Construction, Furniture, Fixture, Equipment, Operating Capital etc.)

ü    Financial Sources & Their Distribution (Equity / Loan)

ü    Time Value of Money / Discount Rate (1)

ü    Economic Life of the Investment (2)

ü    Scrap Value of the Investment (2)
 

(1) Time Value of Money / Discount Rate

Time Value of Money: “Considering the different values of money gained and money spent (C) at specific time intervals (t) with respect to a specific interest or discount rate (r)"

EXAMPLE:   C x (1 + r)^t = future value

                    C / (1 + r)^t = present value

* For a significant and reasonable comparison of cash outflows and inflows projected for different future time intervals, the cash flows should be brought to the same time level by the right discount rate.

Picking the Right Discount Rate:

1-     Market nominal interest rate + Risk & Inflation Premium

2-     Weighted Average of Equity Opportunity Cost (expected internal rate of return) and Loan Interest Rate

(2) Investment's Economic Life & Scrap Value

Physical Life: The period where production can be maintained and technical jobs can be accomplished.

Economic Life: The period where the demand for the goods and services produced by the establishment exists (usually 20-25 years).

In order to decide on it, an analyst must have:

a.  Good comprehension of the future tourism market

b.  Strong past experience

c.  Intuition towards demand existence

Scrap Value: Terminal monetary value / sales value at the end of investment's economic life.

Criteria required for determining scrap value:

Location, Construction Quality, Physical Life Status, Real Estate Taxation etc.

Methods of Analysis used in Assessment of Financial Outcomes

1) Methods ignoring Time Value of Money:

1.1)Investment Profitability Ratio

1.1.1) Highest Profit Expected / Investment Cost =

Annual Net Profit (depreciation excluded, tax included) / Investment Cost (fixed capital + initial operating capital)

If financing includes both equity and loan, then;

Annual Net Profit (depreciation, interest and tax included) / Equity injected for investment

If the project is to be analyzed in terms of national economy, then;

Income before interest & tax / Investment Cost

1.1.2) Average Net Profit / Average Investment Cost =

t = 1,2,3,………n

Pt,    annual net profit for t period

Cw,   working capital

Cs,    fixed capital

n,     economic life

H,     scrap value

1.2) Payback period

If annual cash flow is fixed, then ;

Investment Cost / Annual Cash Flow

If annual cash flow is fluctuating, then;

2) Methods taking Time Value of Money into consideration:

2.1) Net Present Value: The difference between the cash inflows and outflows discounted at a specific rate (if positive, then feasible)

                        n

NPV = G – Y = ΣAt/(1+r)^t + H/(1+r)ⁿ – Y ≥ 0

                      t=1

G,   Total value of the discounted differences between cash inflows and cash outflows

A,     The difference between the inflow and the outflow for every t period (t=1,2,3,…..n) (net profit + depreciation)

n,      Economic life

Y,     Investment Cost

H,     Scrap value

r,      Discount rate

2.2) Internal Rate of Return (IRR): The discount rate at which the net cash flows is equal to the investment cost

If;

                              n

NPV = G – Y = ΣAt/(1+r)^t + H/(1+r)ⁿ – Y = 0,

                             t=1

G = Y, NPV = 0 then;

r = ???

>>> Interpolation method (a manual trial & error method)

>>> Financial Calculator

>>> MS Excel, IRR Function

In a scenario where the investment is solely financed by a loan, IRR can be considered as the maximum interest rate the investment can bear at a term equal to investment period + economic life.

2.3) Cost/Benefit Ratio or Profitability Index: Discounted cash inflows (benefits) / discounted cash outflows (costs)... If greater than "1", then feasible...

Gt, cash inflow at t period

Ct,  cash outflow at t period 

Cy,  cash outflow at investment period

H,   scrap value

r,    discount rate

NPV versus Profitability Index