Assignment: TreeHouse Hotels
After extensive research, TripleTrees Hotel chain has developed a new concept for family friendly suite hotels called TreeHouse. The executive committee must now determine if the project is a viable one. Each unit in a TreeHouseHotel is a suite that includes a sitting room, kitchenette, and 2 bedrooms. In addition, each property would include a playground for children, child-appropriate videos on demand, an indoor swimming pool, and a gym for adults.
The plan is to locate TreeHouse Hotels just outside cities that regularly receive a large number of visitors. The company plans to locate its TreeHouse Hotels within 15 miles of the city center on highways that provide ready access to the city with a number of family-friendly restaurant chains in the immediate area. TripleTrees executives have also noted the importance of locating these new hotels in the safer areas of the metropolitan region.
Although the ultimate goal is to open TreeHouse Hotels around the country, TripleTree has built its success on a conservative approach. The company regularly develops new hotel concepts by opening one or two properties and making adjustments as necessary before expanding in a more aggressive manner. You are being asked to contribute to the financial analysis that helps determine whether the time is ripe to launch the TreeHouse Hotel concept.
The property committee has paid a $15,000 retainer to local commercial real estate companies to identify possible locations in the Washington, DC and Orlando, FL areas. The DC firm has identified a possible location in Alexandria, Virginia, just outside of Washington, DC. The location would provide families with ready access to historic Old Town Alexandria and Mount Vernon, home of President George Washington. Owners of a hotel built in the 1950s are looking to retire and are interested in selling their property. The location has several restaurants (including Applebee's, Wendy's, Jerry's, Subway, Chile's, Friday's, etc.) as well as a grocery store and drug stores within a 5-minute drive. The property is 20 to 30 minutes from downtown Washington, DC, and there is a Metro station approximately 10 minutes away. (Developers have also suggested that the hotel could provide a shuttle to and from Metro at regular intervals.)
TripleTree property managers believe they can purchase the property for $950,000. The current hotel would be torn down, and a new facility would be built. Construction costs associated with the new hotel are estimated to be $5.5 million. The building will be depreciated on a straight-line basis over 39 years, although only 6-months depreciation will be taken during the first year.
TripleTree Corp. typically looks for positive returns from its projects over a 20-year life. For the purposes of this evaluation, you should assume that the company will sell the hotel in 20 years. TripleTree Corp. has a policy of undertaking general upgrades in its properties every 10 years to keep its hotels looking "fresh." The new hotel would be due for an upgrade in Year 10. The expected cost of the upgrade is $700,000. Further, during Year 11 while the hotel is undergoing its upgrade, only 75 percent of the rooms will be available to book at any given point, thereby cutting into revenues for the year.
Based on recent trends in real estate prices, TripleTree's real estate consultants have predicted that the land and TreeHouse hotel will be worth $3.25 million at the end of 20 years, assuming the upgrades are undertaken.
Demolition of the existing building and construction of the new hotel are expected to take 18 months, so that the hotel would not begin leasing rooms until the second half of the first year. Based on occupancy and rates of other hotels in the area, TripleTree believes its new TreeHouse Hotel will generate $1,500,000 in revenues the first 6 months it is open. Operating expenses during this first 6-month period are expected to be 70 percent of revenues before depreciation (as training of staff, additional advertising, sourcing of inputs, etc. will add to start-up expenses). The investment in inventories (cleaning supplies, complementary soaps, shampoos, etc.) for the start-up is expected to be $50,000. Accounts payable for the hotel chain are expected to increase by $5,000.
In its first full year of operation (Year 2), the Alexandria TreeHouse Hotel is expected to generate $3.5 million in revenues, and operating expenses will fall to 60 percent of total revenues before depreciation.
As the financial analyst charged with assessing the TreeHouse proposal, you will also need to determine the appropriate weighted average cost of capital. The CFO has provided you with the following information.
• TripleTree will issue new bonds to help fund the project. The company currently has 20-year bonds outstanding with a face value of $1,000 and a coupon rate of 5 percent, payable annually. The bonds are currently selling for $1,136. The CFO expects to be able to issue new bonds at the rate indicated by the yield on existing bonds.
• TripleTree will also use retained earnings to help fund the project. TripleTree just paid a dividend of $1.50 per share, and its dividends have been growing steadily at 2 percent per year. Its stock currently sells for $12.50 per share.
• The firm's target capital structure is 50 percent debt and 50 percent common equity.
TripleTree Corporation's marginal tax rate is 40 percent.
1. Identify any other questions about the cash flows you would want to ask the executive in charge of the TreeHouse Hotel project. Address those questions to the hotel chain's consultant, Dr. Catherine England.
2. Prepare a spreadsheet identifying the expected cash flows associated with the Alexandria TreeHouse project.
3. Calculate the firm's weighted average cost of capital (WACC).
4. Prepare a memo indicating whether the Alexandria hotel project should be pursued. Different members of the firm's board of directors prefer different measures of a project's viability, so you will need to provide feedback using NPV, IRR, and MIRR.