Running head: MUTUALLY EXCLUSIVE INVESTMENTS

Mutually Exclusive Investments: Hamptons Hotel Case Study

Name
Institution

MUTUALLY EXCLUSIVE INVESTMENTS

Mutually Exclusive Investments: Hamptons Hotel Case Study

Question 1
The cost of capital is the opportunity cost of choosing an investment proposal. In this scenario,
the cost of capital for each investment proposal refer to the rate of return that would have been
earned or generated by putting the same capital into the other investment plan with equal risk.
According to Brusovet al. (2012), the cost of capital for the investment proposals has been
determined using the following formulas.
1. Weighted Average Cost of Capital =Cost of Debt + Cost of Equity
2. Cost of Debt = before tax rate X (1 Marginal tax rate)
3. Cost of equity=Risk-free rate +Beta X (Expected Market Return Risk-Free
Rate)
The cost of investment for the investment proposals is 5.44% and 7.53% for Beta = 1 and
Beta = 1.6, respectively. This indicates that the Four Star Hotel Group considers both
proposals to be in the same risk category. This implies that, in both investment cases, the
management team considers equal volatility in the two investment proposals. That is,
adopting proposal 1 would have equal up and down movement as investment proposal 2
with respect to the existing market. Therefore, in order to determine the best investment
proposal, the management should determine the one with higher return on investment as
projected within the investment period.
Assessment of the proposals risks
There are various ways of assessing risks of investment. They include the determination
of the investments standard deviation, a chance of loss, the magnitude of loss, and Beta
ratios. In this case, I would use standard deviation and Beta ratios. Standard deviation
would indicate how much an investment outlined in each proposal would fluctuate from
the average return.
In this context, investment risk would be taken as inseparable from the Hotels
performance rather than the predominant perception of it being undesirable or a threat to
the investment or something that should be avoided. The investment risk would be
assumed to be the deviation from some expected or targeted outcomes. The Hotels
performance, using any of the proposals, would be expressed in relative or absolute terms
to something else such as a market benchmark. According to Meenan et al. (2010), a
standard deviation can be either negative or positive. Thus, in order for the Four Star
Hotel group to realize meaningful returns, the management team must be ready to face
more short-term volatility. The magnitude of volatility is pegged on the Four Star Hotel
group risk tolerance. Therefore, the standard deviation would be used as an absolute
measure of risk metric and would indicate dispersion around a given central tendency.
Based on the statistical theory, in given outcome normal distributions, any given outcome
would be found within one standard deviation of the mean value which is about 67% of
the period of projection and within 2 standard deviations which is about 95%% of the
period of projection. Therefore, the Four Star Hotel group management team would
expect returns at any given point during the five year period of projection (Meenan et al.,
2010).
On the other hand, Beta ratios would be important in measuring the risk of each
investment proposal relative to the risk of a market benchmark. For example, the Beta
values of 1 in each proposal indicates that the Four Star Hotel group has the same risk as
2

MUTUALLY EXCLUSIVE INVESTMENTS

the market whereas a Beta value of 1.6 means that the Four Star Hotel group has a 1.6 the
risk of the market.

In financial risk, the Beta or coefficient of an investment reflects whether the kind of
proposal to be adopted is more or less volatile compared to the existing market. In the

case for Four Star Hotel group, a

value that is more than 1 implies that the investment
proposal is more volatile that the market and would, therefore, render the investment
profitable. It is worth noting that volatility is a measure of the fluctuation of the prices

about the mean. In other words, volatility of prices is the standard deviation. By using
value it would imply calculating the risk that arises from the exposure to the market

movements. In this scenario, the

of 1.6 has been found to yield a cost of capital of
7.53% in both proposals. This indicates that the investment assets would move up and
down with the market. Therefore, the use of Beta in risk assessment would be essential in
this scenario because, according to the Capital Asset Pricing Model (CAPM), it is the
only kind of risk in which investors would expect a return that is higher than the risk-free
rate of interest (Meenan et al., 2010).
Question 2
Based on the cost of proposals for the Four Star Hotel group and its average risk assets, Proposal
2 creates more value than proposal 1. That is, Proposal 2 yields an average Return on Investment
(ROI) of 73.47% whereas proposal 1 yields a ROI of 71.06%. The ROI is taken over payback
periods of 3.43 and 3.42 for proposal 1 and 2, respectively. Therefore, I would recommend
Proposal 2 over proposal 1. The valuation method in both proposals is based on metrics such as
Net Present Value, Internal Rate of Return and Payback Period. The metrics were used in the
calculation of quantified costs and benefits for the investment. The valuation method recognizes
the risks related to future cash flow, it accounts for the value of money and provides guidance on
the investments value and associated risk. The evaluation method also allows for easy
understanding by stakeholders and the management of when the initial investment should be
recouped.
Nevertheless, the valuation does not indicate when a positive NPV is achieved. That is,
the valuation method presumes an abundant capital and, therefore, there is no capital
rationing. It is impossible to make comparisons because the discount rate changes
annually. The Payback period indicated in the proposals does not take into consideration
the time value for money. The calculation of payback period also ignores cash flows that
take places place after the payback period is reached (Meenan et al., 2010).
Question 3
Upon increasing the Beta value to 1.6, the new cost of capital in both proposals changes
from 5.44% to 7.53%. Therefore, the response to question 2 above does not change
because the two proposals would have the same costs of capital. This indicates that an
increase in the WACC results from the increase in the Beta and the rate of return on
equity. Further, the increase in WACC implies a growth in risk and a drop in valuation. In
this scenario, the valuation assumes both proposals to be in the same risk category as
their and, therefore, increasing the Beta value leads to a proportional increase in the
3

MUTUALLY EXCLUSIVE INVESTMENTS

WACC for both investment proposals. According to Meenan et al. (2010), increasing the
Beta value implies increasing the volatility of the investment. That is, the investment
assets would move up and down with the market. By increasing the beta value, it means
increasing the financial elasticity or measure of sensitivity of the Hotels assets returns to
the market returns. It is also an indication of the Hotels systemic risk, non-diversifiable
risk or market risk. This is reflect as an increased Weighted averages cost of capital in the
two investment proposals
Question 4
To make a more informed decision as to the optimal investment opportunity, I would
need Price/Earnings to Growth ratio (PEG Ratio), Debts -Equity ratio of the company and
price to earnings ratio. For example, the PEG ratio would be useful to determining which
proposal is undervalued. This is because PEG ratio accounts for earnings growth.
Furthermore, the PEG ratio would be a useful metric for obtaining the relative trade-off
between the earnings generated per share, the price of tock and the Hotels expected
growth. According to studies, a lower PEG ration is considered to be cheaper and thus the
best while a higher ratio is considered to be expensive and thus the worst. The DebtEquity ratio would provide more insight on the proportion of financing the company in
the two scenarios. High Debt-Equity ratio for the Four Star Hotel group would indicate
that the company would get over its head in debt. According to Newell & Seabrook
(2006), a High Debt-Equity ratio would indicate the proportion of the shareholders debt
and equity that has been used to finance the Hotel. This ratio is related to leveraging and,
therefore, the ratio is sometime referred to as the Gearing, Risk or Leverage. These two
components (Leverage and Risk) would be obtained from the Hotels statement of
financial position or balance sheet or the so called book value. The ratio can also be
determined from the market values of both investment proposals.
This information, therefore, is crucial in making a more informed decision. Since the
Four Star Hotel group is faced with a difficult time characterized by making loses, the
Price-to-Book ratio is an essential metric as it serves as an indicator of the amount of
money the stakeholders are paying for each dollar of the Hotels earnings. The Price-tobook ratio would also be useful in revealing what the stakeholders are paying for the
tangible assets rather than the harder to value intangibles (Newell & Seabrook, 2006).
The Price-to-Book ratio would also indicate whether or not the Hotels assets are
comparable to the market price in both investment proposals. Thus, this ratio is very
useful in this case it would be used in valuing the investment plans as they are composed
of liquid assets. However, it is important to note that the Price-to-Book ratio is related to
the fundamentals that reflect value in discounted cash flow models. Therefore, the Priceto-Book ratio for the Four Star Hotel group, which is a stable firm, would be determined
using the differential between the hotels return on equity as well as its cost of equity. It is
worth noting that the merit of the Price-to-Book ratio formulation is that it can be used
for companies that do not pay out dividends to their shareholders (Newell & Seabrook,
2006).

MUTUALLY EXCLUSIVE INVESTMENTS

References
Brusov, P., Filatova, T., Orehova, N., &Brusova, N. (2011). Weighted average cost of capital in
the theory of ModiglianiMiller, modified for a finite lifetime company. Applied
Financial Economics, 21(11), 815-824.
Meenan, R. T., Vogt, T. M., Williams, A. E., Stevens, V. J., Albright, C. L., &Nigg, C. (2010).
Economic evaluation of a worksite obesity prevention and intervention trial among hotel
workers in Hawaii. Journal of occupational and environmental medicine/American
College of Occupational and Environmental Medicine, 52(Suppl 1), S8.
Newell, G., & Seabrook, R. (2006). Factors influencing hotel investment decision
making. Journal of Property Investment & Finance, 24(4), 279-294.