Reference no: EM132814103

Luxes Development Co. has identified a historic bank building that could be converted into a hotel. The location is in the heart of a densely populated metropolitan city, and the structure was designed by an acclaimed architect and built in 1913. The fifteen-storey building will be transformed into a boutique hotel with the hotel lobby, meeting rooms, café and fitness area on the first two floors. The remaining thirteen floors will contain 130 guest rooms. The entire project is estimated to cost $35,000,000.

The project will be financed as follows: $21,000,000 of the project cost will be financed through debt, and the remaining cost is being provided by equity investors. The lender is offering a favourable 12% interest rate. Equity investors are requiring a return of 18% on their investment. The current business tax rate is 25%.

Because the structure is historic, Luxes Development Co. has been in discussions with the city government to determine if there are any public incentives for redeveloping this property. The development company knows the hotel supply in this location is underserved and that the city needs additional rooms to attract larger convention groups. The city would also gain from additional jobs and lower unemployment rates.

Problem (a) Determine the Weighted Average Cost of Capital (WACC) with no tax effect.

Problem (b) Determine the Weighted Average Cost of Capital (WACC) with tax effect.

Problem (c) Draw a conclusion based on the answers in (a) and (b).

Problem (d) If the city government offered Luxes Development Co. a tax abatement in the amount of $1,000,000 spread evenly over the first five years of operations, explain how the tax abatement impacts the company's ability to pay debt service.