Evaluation of an investment in a Mid-Budget Branded Hotel

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At Anup N. Amatya & Associates, professional Financial Consultants and Business & Management Consultants, we have evaluated an investment in a Mid-Budget Branded Hotel, similar to ‘Ibis Budget’ and ‘Ginger’ (Indian Hotels Co.).

This segment is absent in the Nepalese market. The investment was somewhat substantial due to initial capital expenditure of over US$ 1 million, as well as ‘Complex’ since we needed to estimate appropriate Cost of Equity and Weighted Average Cost of Capital, WACC for DCF calculation.

Estimating Cash Flows for evaluating the investment in a Mid-Budget Branded Hotel becomes even more Complex in Frontier Markets

The future cash flows are highly uncertain. Estimating these becomes even more complex in Frontier Markets such as Nepal due to lack of sufficient data. Moreover, rating agencies such as Moody’s have yet to rate Nepal, among others, for its Sovereign rating. To alleviate this problem to some extent, ‘Shadow Sovereign Ratings’ was published by The World Bank on 08/2011. Available from: http://documents.worldbank.org/curated/en/125821468332693455/pdf/638890BRI0Econ000public00BOX361532B.pdf

As per Professor Aswath Damodaran from NYU, Stern, ‘Default Spread’ for Nepal is 7.69% for the Shadow rating of CCC+ (Caa1 as per Moody’s) as estimated by The World Bank. SOURCE: Aswath Damodaran, adamodar@stern.nyu.edu. Estimating Country Risk Premiums. Updated 1/1/2018. Available from: http://people.stern.nyu.edu/adamodar/pc/datasets/ctryprem.xls

According to Professor Aswath Damodaran, for the Frontier markets, equities are on average 1.5 times riskier than bonds (implied by the standard deviation in returns from equity and bonds). Nepal’s Equity Risk Premium – ERP from a Global Investor’s perspective is 16.54% = 5% (Mature Market Premium) + (769*1.5 = 11.54%; CRP).

An average Local Investor has fewer Investment Opportunities than a Global Investor

However, an average Local Investor has fewer investment opportunities than a Global Investor, hence can expect a lower ERP. Assuming a Local Investor has access to only 1/3 the investment opportunities to that of a Global Investor, his/her ERP would be 8.85%; {5%+ (769/3)*1.5%}. ERP = Market Return-Risk Free Rate.

Estimating ‘Beta’ that measures the Systematic/Market Risk of the company’s cash flows is also rudimentary since specific data for Nepal is not available. Fully diversified Foreign Investor can use proxy Unlevered beta for Emerging markets. (Unlevered beta, Hotel/Gaming, Emerging Markets=0.84 and India=0.94). SOURCE: Aswath Damodaran, Updated 5/1/2018. Available from: http://people.stern.nyu.edu/adamodar/pc/datasets/betaemerg.xls

Estimating Cost of Equity, Keg and Weighted Average Cost of Capital, WACC, for an investment in a Frontier Market such as Nepal

Our assumed Unlevered Beta, Bu, is 1.0, being a ‘Completely Undiversified Local Investor’. Estimated Cost of Equity, Keg and WACC with 40% Debt and 60% Equity in the Capital Structure:

Bg, Levered Beta =1.50. Here, Bu = Bg {Ve/Ve+Vd(1-t)}+ Bd, Debt Beta=0. From CAPM: Keg=Risk Free Rate (5 year Govt. Bond @ 6%) + Beta * ERP (for a Local Investor) = 6%+1.5*(8.85%) = 19.28%.

Hence, WACC = Keg*Ve/(Ve+Vd)+Kd(1-t)*Vd/(Vd+Ve) = 19.28%*(60/100)+12.5%(1-0.25)*(40/100) = 15.32%. Here, Cost of Debt, Kd = 12.5% and Corporate Tax Rate, t = 25%.

The Estimated Cost of Building and Furnishings for an investment in a Mid-Budget Branded Hotel

Land available for the building was 8,214 sq. ft., with 10,062 sq. ft. floor area (19,166 sq. ft. total land available) acquired 20 years back @ NRS 10 million, the Cumulative value is 10m*(1.08)^20 = NRS 46,609,571=US$ 435,603 (1 US$ = NRS 107) with ‘Benchmark’ Interest Rate of 8% (highest value for 2003-2018).

The total estimated cost of building and furnishing came to US$ 996,351. With a total of 25 rooms retailing at US$40 and occupancy starting from 20% in year two and reaching 70% from year ten onwards, NPV with a discount rate of 15.3% is US$ 606,584 (with 40 years & 22-40 years of terminal cash flow). It excludes land value owned by the investor. The discounted payback period is in the 14th year.

We assumed the long-term inflation rate at 6.1% and estimated the fixed cost of rooms (including staff salary) at 20% of the rental fee irrespective of the occupancy rate. With these initial results, the project looked feasible. Click here for detailed NPV calculation.

Recommendation – Need Sensitivity Analysis

With these initial results, we recommended that the project looked feasible but advised further Sensitivity Analysis with a higher cost of capital, fixed cost of rooms, room occupancy rate, inflation etc. for the proposed investment in a Mid-Budget Branded Hotel before the final decision.

With some investigation, we’ve found that the actual current market price of land is around US$785,046 for 8,214 sq. f.t. It, hence, underestimates the initial investment. In this evaluation, the estimated starting rental cost of rooms are US$40 (growing at 6.1% p.a. with projected long term inflation @ 6.1% p.a.). The occupancy rate starts from 20% in year two, reaching 70% from year ten onwards.

Estimated fixed cost of rooms is at 20% of the rental, irrespective of the occupancy rate and meals for two persons per room @ US$20*2 (growing at 6.1% p.a.) with 50% profit margin. The above assumptions may not materialise since there is intense price competition in the 3-star category and below hotels in Nepal.

Another concern is that the Inflation rate in Nepal, historically, is quite volatile. Source: IMF Data Mapper, https://www.imf.org/external/datamapper/PCPIPCH@WEO/OEMDC/CHN/NPL

Sensitivity Analysis

With a higher cost of capital, WACC at 19%, NPV is US$ 113,574 and DCF Payback period is on the 21st year. Clearly, the investment is not as attractive. Similarly, if fixed total costs of rooms increased by 30% from PV of US$ 630,933 to US$ 820,213, an increase of US$ 189,280, NPV would fall by the same amount from US$ 606,584 to US$ 417,304, a fall of 31.20%. Hence, we recommended further analysis before proceeding with the proposed investment in a Mid-Budget Branded Hotel. Click here for detailed NPV calculation.

 

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Author:  Anup Narsingh Amatya