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
2,040,00
0
(192,500)

Year 2
2,040,00
0
(192,500)

Year 3
2,142,00
0
(192,500)

Year 4
2,142,00
0
(192,500)

Rental Income

---

Depreciation
Increase in repair and
maintenance expenses

---

(10,000)

(10,000)

(10,000)

(10,000)

Decrease in net room revenue

---

(1,650,00
0)

(1,683,00
0)

(1,767,12
5)

(1,855,50
0)

---

187,500

154,500

172,375

84,000

---

(56,250)

(46,350)

(51,713)

(25,200)

Net Operating Income

---

131,250

108,150

120,662

58,800

Depreciation

--(770,00
0)
(770,0
00)

192,500

192,500

192,500

192,500

---

---

---

---

323,750

300,650

313,162

251,300

292,325

245,117

230,536

167,039

Additional Operating
Income
Taxes

Capital Expenditure
Operating Cash Flow
Discounted Operating Cash
Flow (10.75% discount rate)

(770,0
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

-----

---

4,905,600
(1,226,400
)
(1,079,232
)
(283,333)

5,150,880
(1,287,720
)
(1,133,194
)
(283,333)

5,408,424
(1,352,106
)
(1,189,853
)
(283,333)

5,678,845

Food and Beverage Cost

4,672,000
(1,168,000
)
(1,027,840
)
(283,333)

(12,493,446
)
(283,333)

5,962,787
(1,490,697
)
(1,311,813
)
(283,333)

---

(10,000)

(10,000)

(10,000)

(10,000)

(10,000)

(10,000)

Other Operating
Expenses
Depreciation
Increase in repair and
maintenance expenses

---

(1,419,711)

Decrease in net room

revenue
Additional Operating
Income
Taxes

---

(1,650,000
)

(1,683,000
)

(1,767,125
)

(1,855,500
)

(1,892,500)

(1,930,375
)

---

532,827

623,635

669,508

717,631

823,955

936,569

---

(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

--(1,700,000
)
(1,700,00
0)

283,333

283,333

283,333

283,333

283,333

283,333

(283,333)

(283,333)

(283,333)

(283,333)

(283,333)

(283,333)

372,979

436,544

468,656

502,342

576,768

655,598

(1,700,00
0)

336,775

355,911

345,003

333,906

346,165

355,284

Capital Expenditure
Operating Cash Flow
Discounted Operating
Cash Flow (10.75%
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:

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 %)

Planet Karaoke
Pub
2.46

Beach Karaoke
Pub
3.84

3.01

4.95

39
165,017
21
529,206

30
373,043
17
87,545

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.