Phuket Beach Hotel: Valuing Mutually Exclusive Capital Projects

(Case 27-3)

The unused space of the Phuket Beach Hotel was initially meant for the
construction of an alley linking to its new wing which would not be completed
until two years later.

The Planet Karaoke Pub made an offer to Mike Campbell (General Manager,
Phuket Beach Hotel) to sign a four year lease agreement with 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 hotels construction of the alley. Hence, it was envisaged that the
proposed pub would not affect the construction plan of Phuket Beach Hotel.

In the hotels present capital budgeting system, two criteria are deemed
important in project valuation / ranking:
Payback period
Return on investment

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

Planet Karaoke Pub

Up-front renovation costs ranged between 770,000.00 baht and
1,000,000.00 baht.
With zero salvage value, the costs are depreciated using the straight
line method.
Pro-rata allocation of existing overhead expenses (i.e. toilets,
elevators, carpets), based on projected floor area used, amounted to
55,000.00 baht.
10,000.00 baht is charged for the increase in repair and maintenance
costs due to increase in activity.
The pub would pay all utility and other expenses.

Beach Karaoke Pub

Up-front investment ranged between 800,000.00 baht and
1,200,000.00 baht.
Other capital investment (i.e. chairs, bar tables, kitchen set-up, and
karaoke equipment) amounted to 900,000.00 baht.
 Revenue is expected to be composed of 50% walk-ins and 50% hotel
guests.
Estimated total sales for the first year would be at 4,672,000.00 baht
(assumed 64 covers per day 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 baht is charged for the increase in repair and maintenance
costs due to increase in activity

This 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 Hotels 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 owners 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 Wanida
Daoruang (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.

To further improve her project evaluation / ranking, 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. 13,464,000 14,137,000 18,844,000 15,140,000 15,443,00
revenue 00 .00 .00 .00 .00 .00
 % change --- 1.96 4.76 24.98 (24.46) 1.96

At home, Wanidas 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.

Considering the foregoing facts and analyses, the calculated cash flows for
Planet Karaoke Pub is provided as follows:

Planet Karaoke Pub

(Figures in Baht)

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

2,040,00 2,040,00 2,142,00 2,142,00
Rental Income ---
0 0 0 0
Depreciation --- (192,500) (192,500) (192,500) (192,500)
Increase in repair and
--- (10,000) (10,000) (10,000) (10,000)
maintenance expenses
(1,650,00 (1,683,00 (1,767,12 (1,855,50
Decrease in net room revenue ---
0) 0) 5) 0)
Additional Operating
--- 187,500 154,500 172,375 84,000
Income
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
(770,00
Capital Expenditure --- --- --- ---
0)
(770,0
Operating Cash Flow 323,750 300,650 313,162 251,300
00)
Discounted Operating Cash (770,0
292,325 245,117 230,536 167,039
Flow (10.75% discount rate) 00)
Note: Patronage factor is 0.5 (12.5% reduction in net room revenue)

On the other hand, Beach Karaoke Pubs cash flow estimations are the following:

Beach Karaoke Pub

(Figures in Baht)

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
(1,168,000 (1,226,400 (1,287,720 (1,352,106 (1,490,697
Food and Beverage Cost --- (1,419,711)
) ) ) ) )
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 (1,930,375
--- (1,892,500)
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 Income --- 372,979 436,544 468,656 502,342 576,768 655,598
Depreciation --- 283,333 283,333 283,333 283,333 283,333 283,333
(1,700,000
Capital Expenditure (283,333) (283,333) (283,333) (283,333) (283,333) (283,333)
)
(1,700,00
Operating Cash Flow 372,979 436,544 468,656 502,342 576,768 655,598
0)
Discounted Operating
(1,700,00
Cash Flow (10.75% 336,775 355,911 345,003 333,906 346,165 355,284
0)
discount rate)
Note: Patronage factor is 0.5 (12.5% reduction in net room revenue)

In the project evaluation / ranking, the relevant data ought to be considered are
the following:

Planet Karaoke Beach Karaoke

Pub Pub
Payback Period (in years) 2.46 3.84
Discounted Payback Period (in
years) 3.01 4.95
Average Return on Investment
(in %) 39 30
Net Present Value (in baht) 165,017 373,043
Internal Rate of Return (in %) 21 17
Equivalent Annuity (in Baht) 529,206 87,545
Weighted Average Cost of
Capital (in %) 10.75 10.75

The Weighted Average Cost of Capital (WACC) determines the discount rate to be
used in evaluating the two projects. It is computed as shown:

WACC = We*Ke + Wd*Kd*(1-t)

Given:
We = proportion of debt in total financing = 25%
Wd = proportion of equity in total financing = 75%
Ke = cost of equity = 12%
Kd = cost of debt = 10%
t = tax rate = 30%

WACC = 0.75*0.12 + 0.25*0.10*(1-0.30) = 10.75%

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.

Therefore, the Planet Karaoke Pub is to be recommended to the board of

directors due to its higher Average Return on Investment within a shorter
Payback Period.