The global economic crisis has revealed that decision makers need to focus on the fundamentals of business. This article looks at some of the essential elements of Economic Value Added (EVA).

Adding economic value is the core purpose of all hotel businesses - those hotels in operation and those being planned. In some parts of the world, and particularly in the United Arab Emirates where I lived for the past ten years, decision makers have occasionally ignored the fundamentals with disastrous results as far as the losses investors and operators are now facing.

EVA is nothing new to the business world but it has been neglected by many investors, especially in the hotel sector and especially in the Middle East by private owners and even by public companies.

True cost of capital

EVA established the true cost of all capital employed by private owners or shareholders. It measures the minimum return required in order to add value and create real wealth for the investors.

The true cost of all capital employed is the weighted average cost of capital (WACC), which includes the cost of borrowing, as well as the cost of equity. The investor knows the cost of the borrowed capital, at least in the short term, but what about the cost of equity, the money that the private owner or the shareholders provide? The true cost of equity is what the owner or the shareholders could be getting in dividends, price appreciation, or the return on investing in an almost risk-free secure investment such as 10-year government bonds.

The WACC is the return required to justify going ahead with a project. This is the minimum discount rate by which the net present value (NPV) of the project is calculated. A similar measure is the internal rate of return (IRR) which is the discount rate that gives an NPV equal to zero.

As virtually all hotel activities are 'local businesses', the return on individual hotel projects should be adjusted to local circumstances (currency) such as interest rates.

WACC should be based on the local interest rate (10-year government bonds) and include a risk premium for the equity portion to be determined by the owner or the board of directors; it also assumes a standard tax rate to arrive at the cost of equity before tax.

For the debt portion, a spread should be applied in order to assess the cost of debt. The spread, usually 1% or more, is also determined by the owner or the board of directors according to the current market conditions.

The mix of debt and equity should also be determined by the owner or the board members but it is generally recommended for hotel projects to utilise 60% debt to 40% equity (see WACC calculation model below).

Calculating WACC

The WACC is calculated on the forecasted net cash flow to be generated by the project i.e. cash flow from operations. Depreciation as well as debt service and income tax should NOT be included as the required level for the WACC is set to cover these payments.

Of course, the maximum financial risk that a company takes on should reflect the owner's attitude to risk so that no additional projects are carried out beyond a certain point, whatever the profitability might be. However, there are a few tests which a new project should pass to be viable.

1) Does it offer a positive net present value (NPV)?

2) Does the company overall debt-to-equity ratio remain below the gearing set by the owner or the board of directors for the project?

3) Will the project give returns in excess of the company's hurdle rate; preferably if the project is strategically right and if the company has enough financial basis to include new projects.

While EVA is one of today's most talked about measures in business, it's not a new idea but it has sometimes been lost in accounting and other financial measures muddles.

WACC calculation model

Cost of equity

1) Inflation (as forecasted in the financial projection) %

2) Real interest %

3) Risk free interest (10 years' government bonds) total (1 & 2) %

4) Risk premium (share holders calculated return) %

5) Return required (after tax) total (3 & 4) %

6) Tax %

7) Total cost of equity total (5 & 6) %

Cost of debt

8) Risk free interest (per 3 above) %

9) Spread %

10) Total cost of debt (borrowing) Total (8 & 9) %

Gearing (example)

11) Equity (40%) 40% of (7) %

12) Debt (60%) 60% of (10) %

WACC (before tax) Total (11 & 12) %

Note:

1. The above WACC is your minimum NPV to be used for your forecasted operations cash flow.

2. The IRR should exceed the above WACC for the project to be a viable investment.

A timely reminder

I trust this article is a timely reminder to hotel investors about how essential it is to make sound business decisions. Calculating the WACC is one key element of cash flow projections. Decisions based on such an analysis, however, will only come to fruition if trading and other aspects of the projections are pragmatic and realistic