Phuket Beach Hotel: Valuing Mutually Exclusive Capital Projects

1. Assess the economic benefits associated with each of the capital projects. What is the initial outlays? What
are the incremental cashflows over the life of the project? What is the appropriate discount rate to use for
discounting the cashflows of the projects?
The unused space of the Phuket Beach Hotel was initially meant for the construction of an alleylinking to
itsnew wing which would not be completed until two years later

ThePlanet Karaoke Pubmade an offer to Mike Campbell (General Manager, Phuket Beach Hotel) to sign a
four–year lease agreementwith the hotel for the unused space. It proposed for the following:

 A monthly rental fee of 170,000.00 baht for the first two years. Thereafter, a 5% increment for the next two years.
 70% of the unused space (3,000.00 sq. feet) would only be used to give way for the hotel’s construction of the
alley. Hence, it was envisaged that the proposed pub would not affect the construction plan of Phuket
Beach Hotel.

In thehotel’spresent capital budgeting system, two criteria are deemed important in projectvaluation /
ranking:

 Payback period
 Return on investment

Upon Mike’s meeting with Kornkrit Manming (Financial Controller, Phuket Beach Hotel), the latter was
asked to make an analysis of the project offer. This was done bycomparing the offer of Planet Karaoke Pub against
the estimated revenues and costs of an alternative wherein the hotel would havea pub for itself. Thus, his corresponding
analyses are as follows:

Planet Karaoke Pub

 Up-front renovation costsranged between770,000.00 baht and 1,000,000.00 baht.

 Withzero salvage value, the costs aredepreciatedusing thestraight line method.
 Pro-rata allocation of existing overhead expenses(i.e. toilets, elevators, carpets), based onprojected floor area
used, amounted to55,000.00 baht.
 10,000.00 bahtis charged for theincrease in repair and maintenance costsdue to increase inactivity.
 The pub would pay all utility and other expenses.

Beach Karaoke Pub

 Up-front investmentranged between800,000.00 baht and 1,200,000.00 baht.

 Other capital investment(i.e. chairs, bar tables, kitchen set-up, and karaoke equipment)amounted
to900,000.00 baht.
 Revenueis expected to be composed of 50% walk-insand50% hotel guests.
 Estimated total sales for the first yearwould be at4,672,000.00 baht(assumed 64 covers perday with average
check of 200 baht).
 With a 32-seat capacity,tables had to be turned at least twice a day.
 Operating hours would be from 5pm until midnight.
 Project length is six years with a sales growth of 6% per annum in terms of the average check.
However, growth in covers would be limited due to limited capacity.
 Food and beverage costs account 25% of sales.
 Salary expenses account 16% of sales. And also, staff could be recruited internally because the hotel had
excess manpower.

 Other operating expenses account 22% of sales.

 With zero salvage value, the costs (i.e. equipment and furniture) are depreciated using the straight line
method. In addition, annual capital expenditure equaled depreciation.
 10,000.00 bath is charged for the increase in repair and maintenance costs duet to increase in activity.

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Calculated cash flows for Planet Karaoke Pub is provide as follows:

Planet Karaoke Pub

(figures in Bath)

Cash Flows Year 0 Year 1 Year 2 Year 3 Year 4

Rental Income --- 2,040,000 2,040,000 2,142,000 2,142,000
Depreciation --- (192,500) (192,500) (192,500) (192,500)
Increase in repair and
--- (10,000) (10,000) (10,000) (10,000)
maintenance expenses
Decrease in net room revenue --- (1,650,000) (1,683,000) (1,767,125) (1,855,500)
Additional Operating income --- 187,500 154,500 172,375 84,000
Taxes --- (56,250) (46,350) (51,713) (25,200)
Net Operating Income --- 131,250 108,150 120,662 58,800
Depreciation --- 192,500 192,500 192,500 192,500
Capital Expenditure (770,000) --- --- --- ---
Operating Cash Flow (770,000) 323,750 300,650 313,162 251,300
Discounted Operating Cash
(770,000) 292,325 245,117 230,536 167,039
Flow (10.75% discount rate)

Beach Karaoke Pub’s cash flow estimation are the following:

Planet Karaoke Pub

(figures in Bath)

Cash Flows Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

Sales --- 4,672,000 4,905,600 5,150,880 5,408,424 5,678,845 5,962,787
Food and
Beverage --- (1,168,000) (1,226,400) (1,287,720) (1,352,106) (1,419,711) (1,490,697)
Cost
Other
Operating --- (1,027,840) (1,079,232) (1,133,194) (1,189,853) (12,493,446) (1,311,813)
Expenses
Depreciation --- (283,333) (283,333) (283,333) (283,333) (283,333) (283,333)
Increase in
repair and
--- (10,000) (10,000) (10,000) (10,000) (10,000) (10,000)
maintenance
expenses
Decrease in
net room --- (1,650,000) (1,683,000) (1,767,125) (1,855,500) (1,892,500) (1,930,375)
revenue
Additional
Operating --- 532,827 623,635 669,508 717,631 823,955 936,569
income
Taxes --- (159,848) (187,090) (200,852) (215,289) (247,186) (280,971)
Net
Operating --- 372,979 436,544 468,656 502,342 576,768 655,598
Income
Depreciation --- 283,333 283,333 283,333 283,333 283,333 283,333
Capital
(1,700,00) (283,333) (283,333) (283,333) (283,333) (283,333) (283,333)
Expenditure
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Operating
(1,700,00) 372,979 436,544 468,656 502,342 576,768 655,598
Cash Flow
Discounted
Operating
Cash Flow
(1,700,00) 336,775 355,911 345,003 333,906 346,165 355,284
(10.75%
discount
rate)

2. Rank the projects using various measures of investment attractiveness. Do all the measures rank the
projects identically? Why or why not? Which criterion is the best?
The existing capital structure of the hotel would be needed in the project valuation / ranking according to the
earlier mentioned capital budgeting system criteria. Hence, Phuket Beach Hotel’s capital structure is depicted as
follows:
 Consists of 75% equity and 25% debt.
 The debt consisted entirely of Siam Commercial Bank Loans bearing an interest of 10%.
 The hotel owner’s cost of equity was 12%.
 The corporate tax rate was 30%.
For project evaluation / ranking, Kornkrit would now delegate the estimation of future profits, payback period
and average return on investment to WanidaDaoruang (Assistant Financial Controller, Phuket Beach Hotel). As
proposed by him, the future profits would be discounted at 5% since this is the interest earned from their time
deposits at Siam Commercial Bank. Considering the sufficiency of cash on hand to finance the projects, the cost
of debt would no longer be accounted in the estimation of the discount rate.

3. Are the projects comparable based on the standard NPV measure, given that they have unequal lives? What
adjustment or alternative method is required in comparing such projects?
In order to compare the two projects amidst difference in lives, the Net Present Value and Average Return on
Investment could be used. The Net Present Value reflects the most noticeable difference between Planet
Karaoke Pub and Beach Karaoke Pub because the net operating cash flow of the latter is twice as high as
compared with the former. However, this does not sufficiently posit an advantage as it merely accounts the
present level of cash flows within a specified period in time. The Average Return on Investment and Internal
Rate of Return, on the other hand, reflect an actual rate of increase of this flows

4. How sensitive is your ranking to change the discount rate? What other “key value drivers” would affect the
attractiveness of the projects? Estimate the sensitivity of you result to change in any of the key value drivers.
Wanida also considered the possible security problems that may arise from unwelcome guests that could bring a
negative factor with tourists travelling with children. Consequently, these accounted 25% of the total patronage.
The relevant figures are shown below:

Projection of Net Room Revenue (in Baht) ( = Room Sales – Room Operating Expenses)
Year 1 2 3 4 5 6
Net room
13,200,000.00 13,464,000.00 14,137,000.00 18,844,000.00 15,140,000.00 15,443,000.00
revenue
% change --- 1.96 4.76 24.98 (24.46) 1.96

At home, Wanida’s social worker husband reminded her of the increasing number of drug arrests in
Karaoke pubs. He also suggested that the hotel should not be involved in this type of project.

5. Which project should the hotel undertake?

Planet Karaoke Pub is to be recommend to the board of directors due to its higher Average Return on
Investment within a shorter Payback Period.