In early 2008, you purchased and remodeled a 120-room hotel to handle the increa
ID: 1146874 • Letter: I
Question
In early 2008, you purchased and remodeled a 120-room hotel to handle the increased number of conventions coming to town. By mid-2008, it became apparent that the recession would kill the demand for conventions. Now, you forecast that you will be able to sell only 10,000 room-nights, which cost $70 per room per night to service. You spent $20.00 million on the hotel in 2008, and your cost of capital is 20%. The current going price to sell the hotel is $15 million.
If the estimated demand is 10,000 room-nights, the break-even price is $ per room, per night.
(Hint: Remember that the cost of capital is the opportunity cost, or true cost, of making an investment.)
Explanation / Answer
The breakeven price is the average avoidable cost. This can be seen as the annual cost of avoidable capital per room plus marginal costs. The fixed costs are avoidable only through a sale. Which means only $15 million of the original $20million is still avoidable.
Thus breakeven price is PBE= $15 million*20%/10,000 +$70 =$370