Financing Options For A Large Casino/Hotel Project

Running head: Financing Options for a Large Casino/Hotel Project

Financing Options for a Large Casino/Hotel Project

MBA 503- Introduction to Finance and Accounting

Instructer: Cathy Young

University of Phoenix

Introduction

Because the success of casino/resort hotels depends on getting started with the right business plan, it takes a motivated group to ensure success. The business plan will describe the company's financial plan for using the proceeds of the equity offering in a detailed budget showing inflows of capital and expected outflows. Preparing for an equity investment such as, financing to build a casino/resort hotel involves a significant amount of time and attention dedicated to generating a business, strategic and financial plan for the company. In this paper, we will discuss in detail the various options in building a casino/resort hotel.

First, we will discuss the capital valuation model, which combines relative indicators for future performance with basic financial data such as revenue, variable, and fixed costs to value the business. Next, we will describe the characteristics and the cost of various debt and equity instruments since there is significant focus on the cost structure by the potential investor. The cost structure must line up with the requested equity investment or the offering will inevitably fail. In the third section, we will evaluate long-term finance alternatives and identify specific milestones that are recognized by the investment community and assuming that the company correctly forecasted the costs to achieve the designated milestones. A few other options we will discuss is the different sources of capital that are available, compare and contrast the various cash management techniques and finally, compare and contrast the various methods of short-term financing.

Critique of Capital Valuation Models

When financing a large project such as a casino/resort hotel, evaluating the costs of capital is critical. Projections of future revenue will determine the discount rate used by financial managers or investors to determine the present value of the investment. Since the discount rate is a projection, cost of capital estimates are normally projected within a range of discount rates. The cost of capital is an opportunity cost that is equal to the total return that a company's investors could expect to earn by investing in a portfolio of stocks and bonds of comparable risk (Goldberg, 2001).

Companies raise capital for projects in two basic ways: issuing stock (equity) and issuing debt in the form of bonds or bank loans. Using retained earnings is another method of financing that is sometimes discussed as a third option. However, when company management is presumed to be acting in the best interests of the stockholders, the use of retained earnings for financing is equivalent to corporate issue of common stock (Modigliani, 1958).

When financing a $600+ million casino, bonds are the primary instruments for raising capital. Governments play a part in the valuation of bonds by offering tax incentives, since casinos bring new jobs to an area, and increase the tax base. The interest on bonds is tax deductible and is part of the calculation used to determine the total cost of bond issues by an organization.

Casino financing today has a substantial portfolio of high-yield bonds, since these projects many times do not qualify as investment grade securities. The ratings for bonds are calculated by investor services such as Moody's or Standard & Poor. Ratings range from AAA to D. Below a rating of BBB, the minimum standard for investment grade, organizations that want to raise capital must increase the bond yield in order to attract investors. A bond is considered high-yield when the yield is 3%-4% above the price of investment grade bonds (The Bond Market Association, 2006)

The remainder of casino capital is supplied by bank loans and retained earnings, many times by profits on casinos in operation. The discount rate of debt issued in the form of bonds is affected by overall debt of the organization. Many times, the bond rating of a company can fall when high amounts of debt are secured by casino construction. Keeping a favorable debt to earnings rating will mitigate the costs of capital for expanding businesses.

Using the WACC for evaluating financing options

Since firms have the opportunity to use a variety of methods for financing, the calculation for evaluating the cost of capital should be a weighted average cost of capital (WACC). WACC is the after-tax return the company needs to earn in order to satisfy all its equity and debt holders (Brealey, 2003). WACC is calculated by multiplying the cost of each capital instrument by its proportional weight then summing the result. This calculation will describe how much interest the company pays for every dollar it finances (Investopedia, 2006).

Characteristics and Cost of Various Debt and Equity Instruments

There are numerous types of financing instruments that could be used to finance the startup of a new business. Financing instruments generally come in two key categories; debt and equity instruments. According to the Business Resource Center, general debt instruments tend to represent fixed obligations for repayment within a specified period, which includes interest (Raymond 2000). In contrast, equity instruments usually represent an ownership that provides dividend payments when available, but without the right to a return on the capital.

Debt instruments commonly used include notes, bonds, and debentures. These types of debt instruments are given high priority for repayment, including priority above preferred stock holders and common stock holders. This type of debt can either be secured by company assets or less frequently, the debt may not be secured at all. Debt instruments can be either a long-term or short-term in its duration, and may have a fixed rate or adjustable rate of interest. The advantages of debt instruments include regular payments made on the issued debt, and the investor assumes less risk for loss of their investment. The disadvantages to debt instruments include the limitations of the use of working capital because of debt obligations and assets already tied up as collateral for other debt incurred by the company. The casino should consider this as a viable source for a large percentage of the financing.

Another form of financing includes equity instruments.