Assignment Task: HCM Hotels Corporation
Suppose you have recently been appointed as the financial analyst to work for the HCM Hotel Corporation, an international hotel corporation which owns and operate renowned hotel brands all over the world. Your direct supervisor, the regional financial director (RFD) for the Asian-Pacific region has just handed you the estimated cash flows for two proposed investment projects regarding budget hotels. Project M involves constructing a new hotel in a developing area: it would take some time to build up the clientele for this hotel, and so the cash inflows would increase over time. Project P involves renovating of an old hotel building in an economically saturated market, and its cash flows would decrease over time. Both projects have 3-year project lives, because HCM Hotels Corporation is planning to give up the budget hotel segment and enter the up-market hotel segment after 3 years.
Here are the two hotel projects' net cash flows expected in the next 3 years:-
|
|
Expected Net Cash Flow
|
|
Year
|
Project M
|
Project P
|
|
0
|
($100,000)
|
($100,000)
|
|
1
|
$10,000
|
$70,000
|
|
2
|
$60,000
|
$50,000
|
|
3
|
$80,000
|
$20,000
|
Depreciation, trade-in values, net working capital requirements, and tax effects are all included in these cash flows.
The regional financial director also made subjective risk assessments of each hotel project, and he concluded that both projects have risk characteristics which are similar to the company's average project. HCM Hotels Corporation's weighted average cost of capital is 10 percent, As the company's financial analyst, you are now instructed by the regional financial director to determine whether one or both of these two hotel, investment projects should be accepted:
Required:
Question 1:
(a) Define the term 'net present value' (NPV). What is each project's NPV? (Show your workings clearly.)
(b) What is the rationale behind the NPV method? According to NPV, which project or projects should be accepted if they are independent? What if they are mutually exclusive? Justify your answers.
(c) Would the NPV change if the cost of capital changed? Explain.
Question 2:
(a) Define the term 'internal rate of return' (IRR). What is each project's IRR? (Show your workings clearly.)
(b) How is the IRR on a project related to the yield-to-maturity (YTM) of a bond?
(c) What is the logic behind the IRR method? According to IRR, which project or projects should be accepted if they are independent? What if they are mutually exclusive? Justify your answers.
(d) Would the IRR change if the cost of capital changed? Explain.
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