Questions
- Please assess the economic benefits of each of the capital projects by answering the following:
- What is the appropriate discount rate (WACC)?
- What is the initial outlay?
- What are the incremental operating cashflows?
- What are the terminal cashflows?
Case
Phuket Beach Hotel: Valuing Mutually Exclusive Capital Projects Mike Campbell, General Manager of Phuket Beach Hotel, paced his office and considered an offer made by Planet Karaoke Pub. Planet Karaoke Pub was expanding fast in Thailand. It was looking for a venue in Patong beach area for setting up another outlet, and was eyeing an unused space owned by the Hotel. At this point, the space was located on the second floor of the main building and was very much under-utilised. It was reserved for the construction of an alley linking to a new wing for the hotel, which would not be completed until two years later. Planet Karaoke Pub offered to sign a four-year lease agreement with the hotel for renting part of the unused space. It proposed to pay: a monthly rental fee of 170,000 baht for the first two years; and thereafter, a 5% increment for the next two years. In order to accommodate the hotel's expansion plan, Planet Karaoke Pub required only 70% of the unused space, which had a size of 3,000 sq. feet. This would allow the hotel to keep the remaining space for the creation of an alley two years later. It was envisaged that the proposed pub would not affect the hotel's future expansion plan. Nevertheless, Mike was still a bit perplexed about the decision facing him. Similar development proposals had previously been rejected by the board of directors. One of the old proposals, which involved converting the space into a cigar and champagne bar, had been rejected by the board because it required a long payback period. Another proposal for the creation of a spa was discarded due to its low return on investment. Given that the present capital budgeting system ranked projects according to payback period and average return on investment, Mike decided to seek a careful analysis of the offer from the Pub. That evening, Mike asked to meet with Kornkrit Manming, the hotel's Financial Controller, to discuss the offer from Planet Karaoke Pub. Average return on investment = Average annual cashflow after taxes/ Net investment Mary Ho prepared this case under the supervision of Prof. Su Han Chan and Prof. Ko Wang for class discussion. The firms and the individuals in this case are fictional. This case is not intended to show effective or ineffective handling of decision or business processes. This case is part of a project funded by a teaching development grant from the University Grants Committee (AGC) of Hong Kong. Copyright 2001 The University of Hong Kong. No part of this publication may be reproduced or transmitted in any form or by any means - electronic, mechanical, photocopying, recording, or otherwise (including the Internet) - without the permission of The University of Hong Kong. Ref. 01/108C 15 August, 2001 With a seating capacity of 32, the pub had to turn tables at least twice a day. Operating hours of the pub would be from 5:00 p.m. to midnight. The projected length of the project was six years. Sales were expected to grow at 5% per annum in terms of the average check. Growth in covers would be limited due to limited capacity. Kornkrit's estimates for operating costs were as follows: Food and beverage costs Salaries Other operating expenses Depreciation: equipment & furniture 25% of sales 16% of sales 22% of sales Depreciated equally over the life of the project using the straight-line method; with zero salvage value at the end Equalled depreciation Annual capital expenditure Korncrit estimated that salary expenses would account for 16% of sales. Staff could be recruited internally because the hotel had excess manpower at this point. The excess staff had long-term contracts with the hotel and were kept in order to meet the demands of the growing business. Repairs and maintenance costs were estimated to be the same as for Planet Karaoke Pub. Capital Structure Phuket Beach Hotel has a capital structure consisting of 75% equity and 25% debt. The debt consisted entirely of loans from Siam Commercial Bank bearing an interest rate of 10%. The hotel owners' cost of equity was 12%. The corporate tax rate in Phuket was 30%. The Test Kornkrit was quite happy with his estimates, though it had taken him more time than he had originally thought. Now, he had all the figures he needed. The next step was to rank the projects according to the criteria set by the hotel's capital budgeting system. He saved his file and sent it to his new assistant Wanida, a recent graduate from Thammasat University. Here you go, Wanida. This will test what you learnt at business school!, he thought. The following is an excerpt from an email from Kornkrit: To: Wanida Daoruang
From: Kornkrit Manming Subject: Ranking Capital Projects Dear Wanida, ... I have provided you with all the figures you need for the projection of future profits for the two projects. Please evaluate the projects on the basis of their payback period and their average return on investment. Note that future profits should be discounted at 5%. This is the interest rate we earned from our time deposits at Siam Commercial Bank. I believe some of our old proposals were rejected because we used a discount rate that was too high. Since we have enough cash on hand to finance the projects, I don't think we should take into account the cost of debt when estimating the discount rate. Let me know if you have any questions. Regards, Kornkrit Manming * * * Wanida pondered the details of the projects. She thought there was something wrong with the hotel's capital budgeting system, which had not been reviewed for many years. The existing system ranked projects according to their average return on investment and payback period. It seemed to her that something was omitted in the analysis. a Wanida was also aware that certain aspects of the investment decision were difficult to quantify. The Chief Security Officer had expressed his concerns and displeasure over the security problems pub might bring. He was worried pub might attract unwelcome guests from outside. This might be a negative factor for the pub in terms of attracting tourists travelling with children. Wanida thought they accounted for 25% of the total patronage [see Table A for the projection on net room revenue for the next six years). Table A Projection of Net Room Revenue (in Baht) (=Room Sales - Room Operating Expenses) Year Net room revenue 1 2 3 13,200,000 13,464,000 14,137,000 4 5 6 14,844,000 15,140,000 15,443,000 The following are the questions that Wanida considered: 1. What are the relevant cashflows associated with each project? 2. What criteria should be used to evaluate the projects? 3. How can I compare projects with different lives? 4. What discount rate should be used? Wanida thought the discount rate of 5% was too low. Investing in the two projects was certainly more risky than putting the money in the bank. 5. What are the key value drivers and how do they affect the attractiveness of the projects? 6. Which investment project should be recommended to the board of directors? When Wanida got home, she had a talk with her husband about the proposed projects. Her husband, a social worker, reminded her of the increasing number of drug arrests in karaoke pubs. He suggested that as a good member of the community, the hotel should not be involved in this type of project. Phuket Beach Hotel: Valuing Mutually Exclusive Capital Projects Mike Campbell, General Manager of Phuket Beach Hotel, paced his office and considered an offer made by Planet Karaoke Pub. Planet Karaoke Pub was expanding fast in Thailand. It was looking for a venue in Patong beach area for setting up another outlet, and was eyeing an unused space owned by the Hotel. At this point, the space was located on the second floor of the main building and was very much under-utilised. It was reserved for the construction of an alley linking to a new wing for the hotel, which would not be completed until two years later. Planet Karaoke Pub offered to sign a four-year lease agreement with the hotel for renting part of the unused space. It proposed to pay: a monthly rental fee of 170,000 baht for the first two years; and thereafter, a 5% increment for the next two years. In order to accommodate the hotel's expansion plan, Planet Karaoke Pub required only 70% of the unused space, which had a size of 3,000 sq. feet. This would allow the hotel to keep the remaining space for the creation of an alley two years later. It was envisaged that the proposed pub would not affect the hotel's future expansion plan. Nevertheless, Mike was still a bit perplexed about the decision facing him. Similar development proposals had previously been rejected by the board of directors. One of the old proposals, which involved converting the space into a cigar and champagne bar, had been rejected by the board because it required a long payback period. Another proposal for the creation of a spa was discarded due to its low return on investment. Given that the present capital budgeting system ranked projects according to payback period and average return on investment, Mike decided to seek a careful analysis of the offer from the Pub. That evening, Mike asked to meet with Kornkrit Manming, the hotel's Financial Controller, to discuss the offer from Planet Karaoke Pub. Average return on investment = Average annual cashflow after taxes/ Net investment Mary Ho prepared this case under the supervision of Prof. Su Han Chan and Prof. Ko Wang for class discussion. The firms and the individuals in this case are fictional. This case is not intended to show effective or ineffective handling of decision or business processes. This case is part of a project funded by a teaching development grant from the University Grants Committee (AGC) of Hong Kong. Copyright 2001 The University of Hong Kong. No part of this publication may be reproduced or transmitted in any form or by any means - electronic, mechanical, photocopying, recording, or otherwise (including the Internet) - without the permission of The University of Hong Kong. Ref. 01/108C 15 August, 2001 With a seating capacity of 32, the pub had to turn tables at least twice a day. Operating hours of the pub would be from 5:00 p.m. to midnight. The projected length of the project was six years. Sales were expected to grow at 5% per annum in terms of the average check. Growth in covers would be limited due to limited capacity. Kornkrit's estimates for operating costs were as follows: Food and beverage costs Salaries Other operating expenses Depreciation: equipment & furniture 25% of sales 16% of sales 22% of sales Depreciated equally over the life of the project using the straight-line method; with zero salvage value at the end Equalled depreciation Annual capital expenditure Korncrit estimated that salary expenses would account for 16% of sales. Staff could be recruited internally because the hotel had excess manpower at this point. The excess staff had long-term contracts with the hotel and were kept in order to meet the demands of the growing business. Repairs and maintenance costs were estimated to be the same as for Planet Karaoke Pub. Capital Structure Phuket Beach Hotel has a capital structure consisting of 75% equity and 25% debt. The debt consisted entirely of loans from Siam Commercial Bank bearing an interest rate of 10%. The hotel owners' cost of equity was 12%. The corporate tax rate in Phuket was 30%. The Test Kornkrit was quite happy with his estimates, though it had taken him more time than he had originally thought. Now, he had all the figures he needed. The next step was to rank the projects according to the criteria set by the hotel's capital budgeting system. He saved his file and sent it to his new assistant Wanida, a recent graduate from Thammasat University. Here you go, Wanida. This will test what you learnt at business school!, he thought. The following is an excerpt from an email from Kornkrit: To: Wanida Daoruang From: Kornkrit Manming Subject: Ranking Capital Projects Dear Wanida, ... I have provided you with all the figures you need for the projection of future profits for the two projects. Please evaluate the projects on the basis of their payback period and their average return on investment. Note that future profits should be discounted at 5%. This is the interest rate we earned from our time deposits at Siam Commercial Bank. I believe some of our old proposals were rejected because we used a discount rate that was too high. Since we have enough cash on hand to finance the projects, I don't think we should take into account the cost of debt when estimating the discount rate. Let me know if you have any questions. Regards, Kornkrit Manming * * * Wanida pondered the details of the projects. She thought there was something wrong with the hotel's capital budgeting system, which had not been reviewed for many years. The existing system ranked projects according to their average return on investment and payback period. It seemed to her that something was omitted in the analysis. a Wanida was also aware that certain aspects of the investment decision were difficult to quantify. The Chief Security Officer had expressed his concerns and displeasure over the security problems pub might bring. He was worried pub might attract unwelcome guests from outside. This might be a negative factor for the pub in terms of attracting tourists travelling with children. Wanida thought they accounted for 25% of the total patronage [see Table A for the projection on net room revenue for the next six years). Table A Projection of Net Room Revenue (in Baht) (=Room Sales - Room Operating Expenses) Year Net room revenue 1 2 3 13,200,000 13,464,000 14,137,000 4 5 6 14,844,000 15,140,000 15,443,000 The following are the questions that Wanida considered: 1. What are the relevant cashflows associated with each project? 2. What criteria should be used to evaluate the projects? 3. How can I compare projects with different lives? 4. What discount rate should be used? Wanida thought the discount rate of 5% was too low. Investing in the two projects was certainly more risky than putting the money in the bank. 5. What are the key value drivers and how do they affect the attractiveness of the projects? 6. Which investment project should be recommended to the board of directors? When Wanida got home, she had a talk with her husband about the proposed projects. Her husband, a social worker, reminded her of the increasing number of drug arrests in karaoke pubs. He suggested that as a good member of the community, the hotel should not be involved in this type of project
