Unbeknownst to you, he purchased twenty acres of land for $5,000 in Cochise Stronghold 15 years ago. A rancher has been renting the land from him for $600 per acre per year since he bought it. Representatives from the Apache Indian tribe have come to him and proposed that he become their partner in a new hotel/casino project. It’s a pretty simple deal, he contributes the land and pays 50% of the construction costs and he will get 60% of the all of the cash flows. He says it sounds like a great deal, but he’d like you to use all this NPV and payback stuff to tell him whether he should do it. He has always used a 12% discount rate and a four year payback period for evaluating his investments.
He spent $20,000 six months ago with a consultant to get a feasibility study done. The consultant recommended that the hotel be 300 rooms, and predicted that the hotel could run a 60% occupancy rate in its first year and have an average daily room rate of $150. (Note/Hint: Remember that the hotel operates 365 days per year) The occupancy would increase by 2 points per year until it reached a maximum of 75%. The average daily room rate would grow at two percentage points over inflation per year forever. Casino revenue is expected to be $1,000,000 in the first year and will grow with inflation. Revenue other than room rate (restaurant, bars, etc.) is expected to be 20% of total room revenue per year. The consultant estimates that the fixed costs (insurance, property taxes etc) excluding depreciation will total $250,000 in the first year. It is expected these costs will increase with inflation in future years. Variable costs including labor should be 60% of total hotel and casino revenue. A liquidator he knows has already promised to pay him 5% of original purchase price for any furniture and equipment he might want to liquidate, regardless of age or condition.
The tribe has estimated that it will cost $3 million to get the land ready for building, the land will take 6 months to prepare before construction can begin and the building will cost $40 million to construct. Thanks to prefabricated construction; it will only take six months to finish the building. Dad will only have to pay his half of the construction once the building is finished. The equipment and furniture inside the hotel/casino will take another $5 million. The furniture and equipment will need to be replaced after 5 years. Representatives of Donald Trump’s organization have already committed to buying the hotel and casino at the end of the 10th year of operation for $65 million.
You dad called your aunt who is a CPA for advice. She told him that under current tax law the building must be depreciated using straight line method for 27.5 years and the Furniture and Equipment would be 5 year MACRS equipment. She advises that the inflation rate in the US should run 3% the next 10 years. Finally, she said that your Dad’s marginal tax rate was 30%. The tribe because of its sovereign status is exempt from income taxes. She always recommends Dad use a 12% discount rate.
What would your group advise your dad: should he do the deal or not? Why? Please be sure to compute both NPV and payback for him, and make recommendations for him. Be sure to show all computations, and list any and all assumptions you needed to make for the analysis.