1. Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ 07458 Chapter 9 Capital Expenditure Analysis

2. Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ 07458 Objectives  Capital Expenditures  Cash Flows Versus Accounting Income  The Incremental Cash Flow Principle  Opportunity Costs  Tax Considerations  Sunk Costs  Allocated Costs  Excess Capacity  Investment in Net Working Capital  Accelerated Versus Straight–Line Depreciation  Accounting for the Effects of Inflation  Expanding on our Basic WACC Approach to NPV  An Example of Capital Expenditure Analysis  Analyzing Other Types of Projects  Mutually Exclusive Project Alternatives  Capital Rationing

3. Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ 07458 Capital expenditure analysis (CapEx), or capital budgeting involves determining the value-creation potential of a hospitality project Cash Flows Versus Accounting Income cash flow is valued at the time it actually occurs accounting flows are based on accruals, that is, recording a revenue or expense at the time of the transaction whether or not a cash flow has actually occurred

4. Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ 07458 The Incremental Cash Flow Principle The only cash flows that are relevant to the valuation of a hospitality project are the incremental cash flows resulting from the project’s acceptance or undertaking. The incremental cash flows attributable to the project can be estimated by subtracting the cash flows the hospitality firm as a whole would generate without the project from the cash flows the firm as a whole would generate if the project were accepted or undertaken.

5. Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ 07458 Opportunity Costs Such as using assets or other resources that are already owned by the firm Example: suppose a hotel company owns a piece of land worth $1,000,000 (that is, it could be sold today for $1,000,000) and is considering building a hotel on the site. The hotel construction will require an initial investment of $20,000,000. What is the total investment cost that should be attributed to the new hotel project? Time 0 cash flow with the project:-$20,000,000 Time 0 cash flow without the project: $ 1,000,000 Incremental cash flow (“with” minus “without”):-$21,000,000 In other words, if the hotel company doesn’t build the hotel, it could sell the land for $1,000,000, which would represent a $1,000,000 cash inflow. If it builds the hotel, it will have $1,000,000 less in cash, since it cannot then sell the land. This $1,000,000 opportunity cost must be attributed to the project. Hence, the total cost of the project is $21,000,000.

6. Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ 07458 Taxes on the Sale of an Asset If the actual sales price is equal to its depreciated book value, the government views this as simply recovering the remaining value of the investment and there are no tax consequences on the sale If the actual sales price is greater than its depreciated book value, tax will have to be paid on the amount over the depreciated book value (recapture of depreciation) If the actual sales price is greater the original purchase price, a capital gains tax will have to be paid on the amount of the sales price over the original purchase price

7. Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ 07458 Example: A broiler that originally cost $5,000 has a depreciated book value of $1,000 and it is sold for $6,000. Assume that the restaurant’s marginal tax rate is 40% and that the long term capital gains tax rate is 20%. $6,000Sale Price of Broiler - 1,600Tax on Recapture of Depreciation (.4 x ($5,000 - $1,000)) - 200Capital Gains Tax (.2 x ($6,000 - $5,000)) $4,200Net Termination Cash Flow The sale would result in a net cash inflow of $4,200.

8. Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ 07458 Sunk Costs Cash outflows that have occurred before the time when the decision is made to undertake a project. By the ICF principle, they are irrelevant to the decision of whether or not to accept the project.

9. Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ 07458 Allocated Costs  Costs associated with the operation of the hospitality firm as a whole that are apportioned to the various operating areas of the firm on the basis of some “formula.”  For example: administrative and general, other overhead costs  Allocation “formulas” examples: proportional square footage of operating area, dollars of assets employed, dollars of sales generated  By the ICF principle: the only costs relevant to the project are the actual incremental costs that result from the project’s acceptance. Example: because a dining room expansion takes up 40% of the new dining room’s total space doesn’t mean that the project should be allocated 40% of the dining room’s portion of the firm’s overhead costs

10. Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ 07458 Excess Capacity  A project that puts new demands on the resources or assets of a hospitality firm must have the opportunity costs of using those resources borne by the project.  Example: you are evaluating the project of expanding your dining room  You estimate that without the expansion, your current dish machine would have to be replaced in five years.  If you expand, your dish machine will reach capacity in only three years and have to be replaced at that time.  By the ICF principle, the opportunity cost associated with using up the excess capacity of the dish machine would have to be charged to the dining room expansion project.

11. Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ 07458 Net Working Capital Many projects require an investment outflow not only for buildings and/or equipment but also for net working capital (defined as current assets minus current liabilities). Usually assumed that any investment in net working capital is recovered in full at the end of the project’s life. Investment in net working capital may occur at the project’s beginning (time 0) in one lump sum or it might be spread out over several years as sales due to the project gradually increase. Recovery of net working capital investment is usually treated as a cash inflow in the last year of a project’s life.

12. Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ 07458 Accelerated Versus Straight–Line Depreciation Regardless of whether a firm uses straight–line or accelerated depreciation, the total amount of depreciation on an asset will be the same. Benefit that depreciation brings to a project or capex decision: the depreciation tax shield or τΔDEPR t. By maximizing depreciation as early in the project’s life as possible, the timing of the depreciation tax shield cash inflow is changed – more of the depreciation tax shield is received earlier and less later Thus, hospitality firms use accelerated depreciation to maximize the present value of the depreciation tax shields generated by the assets that they employ.

13. Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ 07458 Effects of Inflation Guiding principle: be consistent in your incorporation of the effects of inflation into your project analysis. If you estimate inflated cash flows in the numerator of the NPV calculation, you MUST discount at a nominal required rate of return (that is, one that includes a premium for expected future inflation). Estimating the effect of inflation on each item contributing to the overall OCF t of a project provides a way to account for any differential effects of inflation. The nominal rate of return (that observed in the market) can be thought of as: k nominal = k real + Expected Rate of Inflation Example: if the nominal borrowing rate (k D NOMINAL ) for a project is 12% (that is, the lenders will lend at a rate of 12%) and investors in general expect the rate of inflation to be 5% per year over the life of the loan, our real borrowing cost, k D REAL, will be 7% (12%-5%).

14. Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ 07458 Expanding on our Basic WACC Approach to NPV Basic formulation of NPV: n NPV = Σ OCF t - I 0 t=1 (1 + k A ) t To account for other cash flows such as working capital investment or recovery, an initial investment that occurs over several years instead of just at time 0, project termination cash flows, tax effects on the sale of the project’s assets, etc.: n NPV = ΣNCF t t=0 (1 + k A ) t where NCF (net cash flows) represent OCF t, I 0, or any project-relevant cash flows.

15. Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ 07458 Example of Capital Expenditure Analysis College Town Restaurant is considering replacing its present dish machine with a new, more efficient model. 1. Estimate the depreciation per year for the project. Since the College Town uses straight line depreciation, the depreciation per year will be: DEPR t = ($70,000 – 0)/7 = $10,000 2. Estimate the OCF t for the project. Using an accounting income statement approach (see next slide):

16. Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ 07458 Example of Capital Expenditure Analysis (cont’d)

17. Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ 07458 3. The College Town has estimated that their owners will require a return of 16% (k E ) on an investment with the level of risk of the new dish machine. If the cost of debt to the firm is 10% (k D ) and if the firm finances its projects with a 40-60 mix of debt and equity (i.e., the Leverage ratio is.40 or 40%), what will be the weighted average cost of capital for the project? k A = (1 - L)k E + Lk D (1 - τ) = (1 – (.4)) (.16) + (.4)(.10) (1 -.4) = (.6)(.16) + (.4) (.10)(.6) =.12 or 12% Example of Capital Expenditure Analysis (cont’d)

18. Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ 07458 4. What will be the net cash flow on the sale of the old grill? Sale price:$5,000 Recapture of depreciation: $5,000 (since depreciated book value = 0) Tax on recapture of Depreciation: $5,000 (tax rate) = $5,000(.4) = $2000 Net cash flow on sale of the old grill: $5,000-2,000 = $3,000 Example of Capital Expenditure Analysis (cont’d)

19. Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ 07458 5. Put all of the cash flows relevant to the investment in the new dish machine on a time line: 6. Calculate the net cash flows of the new dish machine investment and put them on a time line: Example of Capital Expenditure Analysis (cont’d) -67,000 -70,000 0 +16,000

20. Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ 07458 7. Calculate the Net Present Value of the new dish machine investment. NPV = 16,000(PVA n=7, k=12 ) - 67,000 = 16,000(4.5638) –67,000 = +6,021 The project is value creating and the new dish machine should be purchased Example of Capital Expenditure Analysis (cont’d)

21. Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ 07458 Mutually Exclusive Project Alternatives Definition: Projects are mutually exclusive; choosing one option automatically excludes accepting any of the remaining Generally presents no problem when NPV is used as the decision criterion It can present problems for other decision criteria (e.g., IRR, payback, etc.)

22. Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ 07458 Capital Rationing Under capital rationing, managers (given the total amount of money they have to invest in projects) select the combination of projects that meets this capital restraint and that maximizes total NPV. This combination of projects is not necessarily found by taking individual projects with the highest NPV. There are techniques such as the profitability index and linear programming models that can help managers deal with this situation.

23. Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ 07458 Summary Capital expenditure analysis is the means by which we determine the value-creation potential of a hospitality project. Correctly determining this potential is critical to the successful operation and expansion of hospitality firms. An important part of capital expenditure analysis is the estimation of the cash flows relevant to the project being evaluated. We have looked at various aspects of this estimation process, including how to handle sunk costs, allocated costs, excess capacity, and taxes on the sale of the project’s assets. We have also seen how the incremental cash flow (ICF) principle, which states that the only cash flows relevant to a project’s value are the incremental cash flows that the project generates, can be used to clarify which cash flows should be attributed to a specific project and which should not. We have also addressed the questions of how to handle inflation and how mutually exclusive project alternatives affect the project decision process.