DEPARTMENT OF MANAGEMENT STUDIES

SML 770 MANAGERIAL ACCOUNTING AND FINANCE

TERM PAPER A CASE STUDY ON NET PRESENT VALUE FOR REVENUE EXPANSION

GUIDED BY:
Prof.P.K.JAIN

SUBMITTEDBY:
VIKALPAWASTHI 2010CEC3853 M.TECH CONSTRUCTIONTECHNOLOGY ANDMANAGEMENT +919873510109

Date : 16th November 2011

APNA HEALTH CLUB Case study on NPV

Introduction The APNA HEALTH CLUB (AHC) was opened in 2004 with a leisure pool, sports hall, 4 squash courts and changing rooms. DARA SINGH is the new and very ambitious manager who himself has been known for his fitness. Squash courts 1 and 2 have been recently refurbished and are fully booked most of the day. The other two squash courts next to the fitness room are now in urgent need of repair and are rarely booked. The fitness room is too small. It is clear that the APNA HEALTH CLUB is losing members because the fitness room is too busy. Other local centres such as TOTAL HEALTH CLUB are reporting a big increase in membership of their fitness rooms. Dara Singh believes it is important to increase the size of the fitness room by incorporating one or both of the squash courts that are rarely booked. Miss Lara is the management accountant for the AHC and she has been asked to evaluate the alternative proposals. Proposals (i) Alternative 1- Incorporate squash court No. 4 Increase the size of the fitness room by incorporating squash court 4. This would increase the size of the fitness room from 2,200 sq. ft to 2,750 sq. ft. Squash court 3 would remain and it would be refurbished immediately. Alternative 2 Incorporate squash courts 3 and 4 Increase the size of the fitness room by incorporating squash courts 3 and 4. This would increase the size of the fitness room from 2,200 sq. ft to 3,200 sq. ft.

(ii)

Capital costs The capital costs of the alternatives include building works, services, equipment, and professional fees. Estimates are given below (Value In Rs.): Building works Alternative 1 (Rs.) Doors Remove existing walls New ceilings Fire exit Decoration Total
44000 88000 76000 132000 284000 624000

Alternative 2 (Rs.)
44000 144000 128000 144000 424000 884000

Services Alternative 1 (Rs.) Electrical Lighting Air conditioning Total Equipment Alternative 1 (Rs.) Cardio-vascular machines (bikes, rowers) Cardio theatre Drinking fountain Total Professional fees and charges Professional fees and charges have been estimated at Rs.240000. (This cost will be incurred as soon as a decision is made) Annual costs The management wants to appoint only one permanent member of staff and then increase the number of casual staff at peak times. A nominal estimate for utilities and cleaning costs has been included in the costings as these costs are not expected to change significantly. The maintenance and repair contracts are for the first year only and the suppliers will not commit themselves to providing estimates after the first year. An estimate for the costs are given below: Alternative 1 (Rs.) Permanent staff Casual staff Utilities Maintenance contracts Cleaning and other
760000 320000 56000 328000 84000 1520000 280000 44000 1844000 160000 80000 560000 800000

Alternative 2 (Rs.)
228000 128000 480000 836000

Alternative 2 (Rs.)
3120000 312000 44000 3476000

Alternative 2 (Rs.)
760000 480000 72000 488000 84000

The cost of advertising the new facilities at the Apna Health Club is estimated at Rs. 600000 in the first year. Dara believed an aggressive advertising policy was essential to ensure the project was a success. No estimate for advertising was considered for later years.

Estimating additional annual revenue for fitness room (two different approaches are to be considered) Dara Dara has suggested that additional revenue should be estimated by dividing the current income of Rs 6600000 by 2,200 sq. ft to determine income per sq. ft. The income per sq. ft. is assumed to remain constant as the size of the fitness room is increased. Basing income on square footage is seen as a simple but accurate way of estimating future income. Lara Lara suggested a different approach. She suggested that managers should use a probability distribution based on the judgement of all the senior managers to estimate the total revenue for the fitness room. After much discussion Lara was able to suggest the following probability distribution: Alternative 1 Probability % 20%

State of World I - The fitness room will be an initial success but too few new members will be attracted. Usage will vary throughout the year. II - The fitness room will be very successful initially but then membership will slowly fall. Usage will be seasonal. III - The fitness room will be very successful. A lot of new members will be attracted and as existing members become more health conscious they will use the room throughout the year.

Total annual revenue for the fitness room. Rs.8400000

Rs.9000000

50%

Rs.10000000

30%

Alternative 2 State of World Total annual revenue for the fitness room. Rs.9600000 Probability % 50%

I - The fitness room will be an initial success but too few new members will be attracted. Usage will vary throughout the year. II - The fitness room will be very Rs.10000000 successful initially but then membership will slowly fall. Usage will be seasonal. III - The fitness room will be very Rs.10800000 successful. A lot of new members will be attracted and as existing members become more health conscious they will use the room throughout the year.

40%

10%

(The additional revenue equals the total revenue calculated above less the existing revenue of Rs.66,00,000). Cost of capital Lara suggests that it is appropriate to use a cost of capital of 12% for this project.

Other related information from Lara Lara wants the following information to be considered.

(1)

Both squash courts 3 and 4 are in urgent need of refurbishment. It has been agreed that if one court is going to be used in the future it will be refurbished immediately at a cost of Rs.23,00,000. If both courts are going to be used in the future they will be refurbished immediately at a cost of Rs.45,00,000. If one court is closed the total income from the squash courts will fall by Rs.450000 per annum. If two courts are closed the total income from the squash courts will fall by Rs.1000000 per annum. (These estimates are based on last years booking information)

(2)

(3)

The restaurant manager expects to see more customers if the fitness room is increased in size. If the fitness room is increased in size by closing one court the restaurant manager estimates his profits will increase by Rs.750000 per annum. If the fitness room is increased in size by closing two courts the restaurant manager estimates his profits will increase by Rs.9500000 per annum.

Life of project The life of the project was discussed at some length by the senior management. Dara wanted to assume that the equipment had a life of 6 years but a more conservative estimate of 5 years was proposed by Experience singh who had experience of a similar project at a different Apna Health Club. Lara suggested that a project life of 4 years should also be considered but this was quickly dismissed by Dara. Tax rate of 35% and depreciation on the equipments is considered for tax advantage by Straight Line Depreciation method with negligible salvage value.

EVALUATION OF ALTERNATIVE 1 A. INCREMENTAL CASH OUTFLOW Incremental cost of building worksBuilding works Doors Removing Existing Walls Fire Exit New Ceilings Decoration Incremental cost for Services Electrical Lightning Air Conditioning Increment cost for Equipments Cardio vascular machines ( Bikes, Rowers) Cardio Theatre Drinking Fountain Professional Fee and Charges ( To be made immidiately) Incremental Cost for labour ( Permanent staff not to be included) Incremental Cost of utilities Incremental Cost for maintainence contract Incremental Cleaning cost Advertisement Cost Cost of refurbishment of existing squash court left Total Incremental Cost (t=0) B. INCREMENTAL CASH INFLOW (1-5) 1 As per Dara proposal Increase in square feet for Alternative 1( 2750sqft-2200 sqft) Rate per Sqft( =6600000/2200) Incremental Revenue from Fitness Room Increase in the profit for restaurant LESS Loss in the revenue from one squash court ( the one removed) Depreciation on additional equipment ( =1844000/5 as per straight line method) Total incremental Earnings Before Tax Taxes (@35%) Total Incremental Earning after Tax Add Depreciation Cash Flow After Taxes C. Determination OF NPV Year Year 1-5 Less Incremental Cash Outflows NPV

44000 88000 132000 76000 284000 624000 160000 80000 560000 800000 1520000 280000 44000 1844000 240000 320000 56000 328000 84000 600000 2300000 7196000

550 3000 1650000 750000 450000 368800 1581200 553420 1027780 368800 1396580

CFAT 1396580

PVIF (0.12) Total PV 3.605 5034671 7196000 -2161329

2 As per Lara proposal Taking the Weighted average of the probable revenues Total revenue Incremental Revenue (=9180000-6600000) Incremental Revenue from Fitness Room Increase in the profit for restaurant LESS Loss in the revenue from one squash court ( the one removed) Depreciation on additional equipment ( =1844000/5 as per straight line method) Total incremental Earnings Before Tax Taxes (@35%) Total Incremental Earning after Tax Add Depreciation Cash Flow After Taxes C. Determination OF NPV Year Year 1-5 Less Incremental Cash Outflows NPV

9180000 2580000 2580000 750000 450000 368800 2511200 878920 1632280 368800 2001080

CFAT 2001080

PVIF (0.12) Total PV 3.605 7213894 7196000 17894

EVALUATION OF ALTERNATIVE 2 A. INCREMENTAL CASH OUTFLOW Incremental cost of building worksBuilding works Doors Removing Existing Walls Fire Exit New Ceilings Decoration Incremental cost for Services Electrical Lightning Air Conditioning Increment cost for Equipments Cardio vascular machines ( Bikes, Rowers) Cardio Theatre Drinking Fountain Professional Fee and Charges ( To be made immidiately) Incremental Cost for labour ( Permanent staff not to be included) Incremental Cost of utilities Incremental Cost for maintainence contract Incremental Cleaning cost Advertisement Cost Total Incremental Cost (t=0)

44000 144000 144000 128000 424000 884000 228000 128000 480000 836000 3120000 312000 44000 3476000 240000 480000 72000 488000 84000 600000 7160000

B.

INCREMENTAL CASH INFLOW (1-5) 1. As per Dara proposal Increase in square feet for Alternative 1( 3200sqft-2200 sqft) Rate per Sqft( =7200000/2200) Incremental Revenue from Fitness Room Increase in the profit for restaurant LESS Loss in the revenue from two squash court Depreciation on additional equipment ( =3476000/5 as per straight line method) Total incremental Earnings Before Tax Taxes (@35%) Total Incremental Earning after Tax Add Depreciation Cash Flow After Taxes

1000 3000 3000000 950000 1000000 695200 2254800 789180 1465620 695200 2160820

C. Determination OF NPV Year Year 1-5 Less Incremental Cash Outflows NPV B.

CFAT 2160820

PVIF (0.12) Total PV 3.605 7789757 7160000 629757

Incremental Cash Inflows (1-5) 1. As per Lara proposal Taking the Weighted average of the probable revenues Total revenue Incremental Revenue (=9880000-6600000) Incremental Revenue from Fitness Room Increase in the profit for restaurant LESS Loss in the revenue from two squash court Depreciation on additional equipment ( =3476000/5 as per straight line method) Total incremental Earnings Before Tax Taxes (@35%) Total Incremental Earning after Tax Add Depreciation Cash Flow After Taxes

9880000 3280000 3280000 950000 1000000 695200 2534800 887180 1647620 695200 2342820

C. Determination OF NPV Year Year 1-5 Less Incremental Cash Outflows NPV

CFAT 2342820

PVIF (0.12) Total PV 3.605 8445867 7160000 1285867

RECOMMENDATION 1. Net Present Value of the Alternative 2 is more than Alternative 1 in both the cases as suggested by Dara and Lara respectively .Dara Singh should go for the Alternative 2 i.e. combining both squash courts to built a larger Fitness centre. 2. The method for calculations of revenue is more consistent and acceptable in case of the method suggested by Lara (Based on the Probability) as it is based on the Judgments of senior managers and is more likely to incorporate most of the risks. The method suggested by Dara Singh may not always give actual results. 3. There are some factors found out to be more sensitive like Cost of Refurbishment of existing Squash courts, Cost of Machinery and equipments, and Loss in the revenue from existing Squash courts. For these Sensitive figures a little modification may change the results , So if some changes can be made possible for these figures , modified Net Present Value of two alternatives may differ and decision can be reconsidered. 4. The additional information not included in the case study is the set of existing data of cost structure , If it is given then NPV for the existing structure of Apna Health Centre can also be compared to the two proposed alternatives as it might be possible to have more Total NPV for the existing systems