Minimizing the Cost of Capital in Hotel Investments

Background

Investing in a hotel involves a big-ticket transaction. From a few million to over a billion US Dollars has been the range of hotel prices observed in recent years. The hotel investment community comprises of a large set of players: high net-worth individuals, boutique partnerships, REITs, pension funds, private equity funds and hotel brands to name a few. The amount of funding required in such projects is significant. Often, financing such assets becomes a complex business problem. Traditionally, a number of cash-surplus entities are selected to pool-in the capital necessary for the acquisition. Also, such investments tend to be highly leveraged. In other words, a large amount of debt capital is combined with equity to meet the amount required for acquisition.

Cash-surplus units (individuals, organizations, firms or governments) offer a broad range of financing alternatives to the investor with various maturity terms, conditions, priority for repayment and, of course costs. What a capital-surplus unit expects as return from her capital is a cost to the cash-deficit unit which is raising the capital. A critical consideration is to minimize the overall cost of capital resulting from the return expectations of the surplus units. A non-optimal capital structure could lead to failure of an acquisition project whereas the acquisition with an optimal financing mix could increase the shareholder wealth. The investment management problem involves

• 1.

  Addressing a set of constraints imposed by the surplus units, and

• 2.

  Allocating the overall cash required towards various surplus units such that not only the constraints are met, but the weighted average cost of capital (WACC) is minimized as well.

Mathematically, solving the minimization problem requires knowledge of differential calculus. Most managers simplify the challenge by resorting to user-friendly, GUI-driven software such as SOLVER.

Multivariate Minimization

Suppose, we are considering sources of capital with their respective costs and allocations denoted as follows: