Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Chapter 9 Hospitality Industry Applications of Time Value of Money Concepts and Skills

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Chapter Overview Questions to consider when Securing a LoanQuestions to consider when Securing a Loan Questions to consider when Raising EquityQuestions to consider when Raising Equity Sensitivity AnalysisSensitivity Analysis

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Loan Components PrincipalPrincipal –Amount of money being borrowed Debt ServiceDebt Service –Fixed payments to the bank Interest RateInterest Rate –Percentage of loan balance Amortization RateAmortization Rate –Number of years debt service payment is based on

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Principal Amount The amount of principal the bank will lend is based on:The amount of principal the bank will lend is based on: –Cash flow projections –Present value of the business –Loan-to-value ratio (LTV) –Loan-to-cost ratio (LTC) –Debt service coverage ratio (DSCR) DSCR = Cash Flow / Debt Service

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved How much can be borrowed? Principal amount is based on:Principal amount is based on: –The amount of money dedicated to debt service –Lender’s terms Amortization rate Interest rate LTV

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Principal Amount Calculation PMTPMT –Amount the borrower is comfortable committing to debt service N –Lender’s amortization rate I/YI/Y –Lender’s interest rate CPT PVCPT PV –Compute for the loan amount

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved What is the maximum interest rate? Interest rate calculation:Interest rate calculation: –PV Amount of the loan determined by the borrower’s needs –PMT Annual debt service payments borrower is comfortable paying –N Lender’s amortization rate –CPT I/Y Interest rate borrower needs to negotiate with the lender

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved What is the maximum amortization rate? Amortization rate calculation:Amortization rate calculation: –PV Amount of the loan determined by the borrower’s needs –PMT Annual debt service payments borrower is comfortable paying –I/Y Interest rate offered by the lender –CPT N Solve for the amortization rate the borrower should negotiate with the lender

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Debt Service Payments Form of annuityForm of annuity An even stream of cash flow for a number of periodsAn even stream of cash flow for a number of periods

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Debt Service Payment Calculation PVPV –Loan amount determined by the borrower I/YI/Y –Interest rate offered by the lender N –Amortization rate offered by the lender CPT PMTCPT PMT –Calculate the debt service payment

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved How much equity can the borrower raise? Function of the deal’s:Function of the deal’s: –Cash flow projections –Equity investor’s hurdle rate Calculate the NPV of the deal utilizing the investor’s hurdle rate as the discount rate IRR of the deal must be higher than the hurdle rate

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Equity Analysis Example | | | | | | Years Years Utilize [CF] button and enter: CF0 = -800 CF1 = 50 CF2 = 100 CF3 = 300 CF4 = 305 CF5 = 320 Investor’s Hurdle Rate = 10% CPT IRR = 8.5% CPT NPV = -$39.49 Investor will not accept the deal.

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Ownership When the IRR is higher than the investor’s hurdle rate, the deal sponsor can ask for:When the IRR is higher than the investor’s hurdle rate, the deal sponsor can ask for: –Carried Interest Ownership percentage with no equity investment –Promoted Interest Ownership awarded after equity investors achieve their hurdle rate –Equity Kicker Percentage of profit on sale of the asset

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved How much ownership should be offered the equity investor? Calculation focuses on cash distributions to the investorCalculation focuses on cash distributions to the investor –Calculate the present value of all cash flows using the investor’s hurdle rate –Divide the equity investment by the present value of future cash flows calculated Cost / PV = amount of ownership which should be offered

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Sensitivity Analysis Method of analyzing investment opportunities by altering the assumptions on which the projections are basedMethod of analyzing investment opportunities by altering the assumptions on which the projections are based –Change key assumptions by +10% and -10% –Objective is to calculate the deal’s upside and downside potential

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Loan Amortization Schedule Provides information on the year, payment, principal, interest, and balance of a a loanProvides information on the year, payment, principal, interest, and balance of a a loan –Debt service payments remain fixed Principal repayment component increases Interest component decreases

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Loan Amortization Calculation Using a business calculator:Using a business calculator: –Step 1: Perform the annuity calculation to determine the annual debt service payment –Step 2: Click on the AMORT function –Step 3: Calculator displays P1 and P2 P1 stands for beginning of period P2 stands for the end of the period –Step 4: Scroll through the worksheet and you will see principal, interest, and balance

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Loan Amortization Example Utilize 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 136, , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Determining Value There are several ways to determine current market or appraised value.There are several ways to determine current market or appraised value. –Cost Approach –Sales Approach –Income Approach –IRR Approach

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Cost Approach to Value Places value on the property based on the:Places value on the property based on the: –Current value of the land –Current cost to rebuild the physical structure –Current cost to replace the existing furniture, fixtures, and equipment Cost required to replace the property as isCost required to replace the property as is –Physical deterioration or functional obsolescence is included in the analysis

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Cost Approach Formula Estimated Additions +Land$250,000 +All improvements (if new) 500,000 +Furniture, fixtures, and equipment 200,000 Estimated Deductions (depreciation) -Physical (50,000) -Functional (75,000) -Economic (85,000) =Value of the Hotel$740,000

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Sales Approach to Value Values a property based on recent comparable salesValues a property based on recent comparable sales –Selling prices of properties of similar size, quality, and market are used to estimate value

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Sales Approach Example Comparable sales for the International Airport Hotel Today’s date: November 30, 2008 Sale date of other full-service hotels: Hotel OrionJanuary 18, 2008 Moon RiverMarch 24, 2005 Blue MarlinJune 22, 2000 Sale date of hotels of comparable competitive markets and attributes: Jade GardenMarch 13, 2008 (full-service airport hotel) The EsmeraldaApril 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 reserved Income Approach to Value Estimates future cash flows including an assumed sale at the end of the analysis periodEstimates future cash flows including an assumed sale at the end of the analysis period Discounts cash flows using WACCDiscounts cash flows using WACC PV is the appraiser’s estimate of current market valuePV is the appraiser’s estimate of current market value –Preferred by most appraisers, buyers, and sellers Takes into consideration the future income potential

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved IRR Approach to Value Used to determine if the asking price yields an IRR that is equal to or exceeds the equity investor’s hurdle rateUsed to determine if the asking price yields an IRR that is equal to or exceeds the equity investor’s hurdle rate –Done by inputting the asking price as the cost in year 0 and inputting each year’s cash flow including the assumed sale

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Lease vs. Purchase Decision Determine if the present value of lease payments is less than the purchase optionDetermine if the present value of lease payments is less than the purchase option –I/Y Cost of capital if you were to purchase the asset –PMT Annual lease payment –N Number of years of the lease –CPT PV Present value of the lease payments

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Analysis of Multiple Investments Return on Investment (ROI)Return on Investment (ROI) –ROI = cash flow / equity investment Advantage –Easy to calculate Disadvantages –Does not take into consideration the:  Time value of money  Potential sales value of the asset

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Analysis of Multiple Investments PV and NPVPV and NPV –The investment is favorable as long as the PV is greater than the cost Advantages –Takes into consideration the:  Time value of money  Potential sales value of the asset Disadvantage –Cannot compare investments with varying costs

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Analysis of Multiple Investments Internal Rate of Return (IRR)Internal Rate of Return (IRR) –Advantages Takes into consideration the: –Time value of money –Potential sales value of the asset –Allows you to compare investments requiring varying amounts of capital –Disadvantages Assumes that cash distributions are reinvested at the IRR rate If a negative cash flow is projected, there is a possibility for multiple IRRs to be computed