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 hotel’s
construction of the alley. Hence, it was envisaged that the proposed pub would not affect
theconstruction plan of Phuket Beach Hotel.

In the hotel’s present capital budgeting system, two criteria are deemed important in project valuation
/ 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 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
onprojected 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
inactivity.
 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
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 baht is charged for the increase in repair and maintenance costs due to increase
inactivity.

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 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 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
13,200,000.00 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.

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

Rental Income - 2,040,000 2,040,000 2,142,000 2,142,000

Depreciation - (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)

On the other hand, Beach Karaoke Pub’s 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

Food and
- (1,168,000) (1,226,400) (1,287,720) (1,352,106) (1,419,711) (1,490,697)
Beverage 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
- (1,650,000) (1,683,000) (1,767,125) (1,855,500) (1,892,500) (1,930,375)
room 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) (290,971)

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
(1,700,000) (283,333) (283,333) (283,333) (283,333) (283,333) (283,333)
Expenditure
Operating Cash
(1,700,000) 372,979 436,544 468,656 502,342 576,768 655,598
Flow
Discounted
Operating Cash
(1,700,000) 336,775 355,911 345,003 333,906 346,165 355,284
Flow (10.75%
discounted rate)

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

Planet Karaoke Pub Beach Karaoke Pub

Payback Period (years) 2.46 3.84

Discounted Payback Period (years) 3.01 4.95

Average return on investment (%) 39 30

Net Present Value (Baht) 165,017 373,043

Internal Rate of Return (%) 21 17

Equvalent Annuity (Baht) 529,206 87,545

Weighted Average Cost Of Capital (%) 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.