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 revenue 13,200,000.00 13,464,000.00 14,137,000.00 18,844,000.00 15,140,000.00 15,443,000.00 % 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 Rental Income Depreciation Increase in repair and maintenance expenses Decrease in net room revenue Additional Operating Income Taxes Net Operating Income Depreciation Capital Expenditure Operating Cash Flow Discounted Operating Cash Flow (10.75% discount rate) Year 0 ----------------(770,000) (770,000) (770,000) Year 1 2,040,000 (192,500) (10,000) (1,650,000) 187,500 (56,250) 131,250 192,500 --323,750 292,325 Year 2 2,040,000 (192,500) (10,000) (1,683,000) 154,500 (46,350) 108,150 192,500 --300,650 245,117 Year 3 2,142,000 (192,500) (10,000) (1,767,125) 172,375 (51,713) 120,662 192,500 --313,162 230,536 Year 4 2,142,000 (192,500) (10,000) (1,855,500) 84,000 (25,200) 58,800 192,500 --251,300 167,039

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 Sales Food and Beverage Cost Other Operating Expenses Depreciation Increase in repair and maintenance expenses Decrease in net room revenue Additional Operating Income Taxes Net Operating Income Depreciation Capital Expenditure Operating Cash Flow Discounted Operating Cash Flow (10.75% discount rate) Year 0 --------------------(1,700,000) (1,700,000) (1,700,000) Year 1 4,672,000 (1,168,000) (1,027,840) (283,333) (10,000) (1,650,000) 532,827 (159,848) 372,979 283,333 (283,333) 372,979 336,775 Year 2 4,905,600 (1,226,400) (1,079,232) (283,333) (10,000) (1,683,000) 623,635 (187,090) 436,544 283,333 (283,333) 436,544 355,911 Year 3 5,150,880 (1,287,720) (1,133,194) (283,333) (10,000) (1,767,125) 669,508 (200,852) 468,656 283,333 (283,333) 468,656 345,003 Year 4 5,408,424 (1,352,106) (1,189,853) (283,333) (10,000) (1,855,500) 717,631 (215,289) 502,342 283,333 (283,333) 502,342 333,906 Year 5 5,678,845 (1,419,711) (12,493,446) (283,333) (10,000) (1,892,500) 823,955 (247,186) 576,768 283,333 (283,333) 576,768 346,165 Year 6 5,962,787 (1,490,697) (1,311,813) (283,333) (10,000) (1,930,375) 936,569 (280,971) 655,598 283,333 (283,333) 655,598 355,284

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 Pub 2.46 3.01 39 165,017 21 529,206 10.75 Beach Karaoke Pub 3.84 4.95 30 373,043 17 87,545 10.75

Payback Period (in years) Discounted Payback Period (in years) Average Return on Investment (in %) Net Present Value (in baht) Internal Rate of Return (in %) Equivalent Annuity (in Baht) Weighted Average Cost of Capital (in %)

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.