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9A85B008

SAPPHIRE BEACH HOTEL LTD.

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Steve Cox prepared this case under the supervision of Professors Larry Wynant and Randy Kudar solely to

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provide material for class discussion. The authors do not intend to illustrate either effective or ineffective
handling of a managerial situation. The authors may have disguised certain names and other identifying
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Copyright © 1985, Ivey Management Services Version: (A) 2004-01-23

In August, J.J. Kimani, the general manager of the Kenya Financial Services
(KFS) branch located in Malindi, Kenya, had just wrapped up a tour of the almost
completed Sapphire Beach Hotel. The three owners of the Sapphire Beach had
expressed dissatisfaction with their present bankers. They had approached KFS,
requesting a takeout loan for their new hotel, which was scheduled to finish
construction soon and open at the end of September. The loan request totalled
Kshs12 million,1 and would be used to pay off the borrowings from the present
banker.

BACKGROUND ON KENYA’S TOURISM INDUSTRY

Tourism in Kenya generated approximately Kshs2,460 million worth of receipts in

1982 (roughly US$216 million) and was one of the major earners of foreign
currency reserves for Kenya. Within East Africa, Kenya was the dominant tourist
centre, overshadowing its neighboring countries in terms of appeal. Tourists had
the choice of cosmopolitan Nairobi, the sun-drenched coast, numerous wildlife
parks throughout the country and the chance to view unspoiled Africa in all of its
beauty. However, the deep economic crisis that the Western economies had
suffered in the early 1980s had a dampening effect on tourism to Kenya and
caused a period of relative non-growth.

1
At the time of the case, US$1 = Kshs13/50 or Cdn$1 = Kshs10/00.

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Hotels and lodges in Kenya differed in their capacities and occupancy levels, as
shown in Exhibit 1. Coastal beach hotels drew the highest percentages of foreign
tourists, and Malindi (where the Sapphire Beach was located) depended very
heavily on foreign tourists for its livelihood. Malindi differed from Nairobi and
Mombasa in that it did not have an international airport to handle tourists and, as
such, was highly dependent on tour packagers.

A key factor within the tourism industry was the relationship that hotels had with
tour booking companies, travel agents and airlines. Often, the latter parties would
hold investment positions in hotels, and would reciprocate by block booking their
clients into those hotels. For instance, the big British multinational, United Touring

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Company, owned a substantial part of the Nyali Beach Hotel (Block Hotels’ five-

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star Mombasa flagship hotel). The Serena Hotel had ownership by Avis, British

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Airways and Lufthansa, among others. When ownership from such parties could
not be obtained, securing management contracts with major hotel management
companies provided access to these networks of contacts and relationships with
travel bookers and agents.
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Tourism observers worried about the effects of recent bad publicity concerning the
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country. The unsuccessful August 1982 coup attempt against His Excellency
President Daniel arap Moi had caused a temporary negative effect on tourism, but
the industry had rebounded. However, other terrorist-related incidents, such as the
1981 New Year’s Eve bombing of the Norfolk Hotel, created fears in the minds of
tourists. Occasional stories of attacks on tourists were often over-magnified in the
European press, despite the fact that such occurrences were very rare.

Many in the industry felt that hotel occupancy figures were increasingly being
inflated by beds filled at extremely low prices. Hotels, especially those suffering
exceptionally low occupancy, offered cut-rate prices and promotions to attract
business. The government had tried to standardize room rental rates, but the policy
had not been very effective. In fact, the industry was increasingly frustrated by
government regulation: currency controls, import restrictions on vehicles,
numerous reporting documents to file and restrictions on charter flights into
Kenya. Although the Ministry of Tourism had recently been trumpeting the goal of
Kenya’s achieving one million tourists per year by 1988, most people in the
industry thought that was an impossible target.

THE SAPPHIRE BEACH HOTEL

Two years previous, three Kenyan businessmen had decided to build a new
beachfront hotel in Malindi. The chosen location would hopefully position it to
capture what they estimated as a growing market for tourism on Kenya’s coast.
Substantial savings could be realized by developing privately, instead of bidding
the project out to a general contractor, so the trio decided to act as their own
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general contractor. They hired their own architects, artisans and workers, and
purchased their own materials. Construction of the hotel commenced in January
and had been scheduled to be completed by June 1. The construction cost of the
hotel had first been estimated at Kshs12.5 million.

The Sapphire Beach Hotel had been designed in the traditional, white stucco
exterior architecture. Sapphire Beach would be classified as a three-star hotel and
would appeal predominantly to a middle class tourist. The hotel would be two
storeys high, with 50 air-conditioned double bedrooms, plus four double bed
penthouse suites. The hotel would also feature a small discotheque, a souvenir
shop, a bar and restaurant, and would be equipped with a swimming pool, a tennis

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court and a very substantial beach frontage on the Indian Ocean. The total built-up

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area of the hotel would be roughly 55,000 square feet. It would be situated just

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outside the town of Malindi.

The construction of the hotel had been plagued with several problems. The first
setback was the abortive coup attempt, which had temporarily caused a dip in
tourism. The second unanticipated setback was a substantial cost overrun in the
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construction of the hotel. The construction had fallen four months behind schedule
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and the owners estimated that additional costs of Kshs2.5 million were to be
expected, bringing the total necessary investment to Kshs15 million.

The construction costs to date of roughly Kshs14 million had been financed from
two sources. First, each of the owners had put up Kshs833,333 in capital, for a
total equity investment of Kshs2.5 million. Second, a major West German bank
had financed the land, buildings, fixtures and equipment with a loan and overdraft
facility totalling Kshs10 million, and had secured a mortgage over the hotel
property and all hotel assets. The rate of interest on this loan had been set at 15 per
cent, with repayments to begin after the hotel opened for business. When the cost
overruns started to occur, the three owners covered the overruns from their own
sources after the West German bank had refused to advance additional funds.

Bookings for the Sapphire Beach would come from three traditional sources:
travel agents, tour group operators and airlines. Bookings consisted of three basic
consumers: business visitors, tourists and vacationing Kenyan residents. The
feasibility study had assumed that Sapphire Beach would be able to attract the
same consumer breakdown as the coastal industry average, namely six per cent
business visitors, 82 per cent tourists, and 12 per cent Kenyan residents.

The published rates for the rooms at the Sapphire Beach would be about the
average of other Malindi hotels: Kshs350 for a single occupancy, Kshs500 for a
double occupancy, and Kshs600 for a triple occupancy. However, these published
rates were not the average that the hotel could expect to earn per room, except for
the rare walk-in consumer. The published rates covered accommodation plus full
board (all meals included at no extra cost) and the free use of hotel facilities. The
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real rate of revenue that the hotel would earn would first take into account the
standard tour agency booking fee of 15 per cent that was paid to the booking agent.
Second, various tour group operators and travel agencies, who would steer most of
the business to the Sapphire Beach, were notorious for driving the per room prices
paid down as far as possible, and were usually successful, given their volume
booking leverage. Net per bed revenues would be well under published rates. The
hotel prepared its estimates based on 108 beds per night over 365 days. The hotel
expected that its average per bed per night revenue contribution would be Kshs150
in the first year, Kshs155 in the second year, and Kshs165 in the third year. This
per room revenue would be allocated 47.5 per cent to accommodation revenues
and 52.5 per cent to restaurant revenues. Any restaurant walk-in trade would be

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included in the category of miscellaneous revenues, but this was expected to be

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small and insignificant.

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As shown in Exhibit 2, the Sapphire Beach owners expected that occupancy rates
for the hotel would be 65 per cent in Year 1; 70 per cent in Year 2; and 75 per cent
in Year 3. In preparing forecasted profit and loss statements for the first three
years, the owners had assumed that restaurant, bar and other sales revenues were
very closely correlated to room rentals. Restaurant sales were forecasted at 110 per
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cent of room revenues, bar sales at 75 per cent of room revenues and other sales
(disco, gift shop, walk-in restaurant trade) at 50 per cent of room revenues. While
the hotel was forecasted to lose money in the first two years of operation, profits
would start being earned in the third year, once the targeted occupancy levels were
reached. The owners had also prepared a schedule of operating expenses (see
Exhibit 3) for their first year.

The owners of the hotel, none of whom had any prior experience in managing a
hotel, were considering the possibility of hiring a management company. They had
just begun making inquiries, and had budgeted Kshs160,000 per year for this
purpose.

THE LOAN REQUEST

The proposed Kshs12 million loan would be repaid by 96 equal monthly

installments (plus interest) and would be covered by a debenture on the assets of
the Sapphire Beach Hotel. An interest rate of 15 per cent per annum would be
charged on a reducing balance basis.

Kimani questioned the achievability of the forecasted occupancy levels of the

Sapphire Beach Hotel given past industry averages. His concern stemmed from
first-hand experience through a previous professional relationship with one of
Kenya’s major hotel chains. Kimani thought it was highly unlikely that Sapphire
Beach would be able to surpass 75 per cent occupancy, given the unavoidable peak
and trough seasonal aspects of the industry, and also a general perception in the
business community that Malindi was currently overbuilt with hotel capacity.
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On the other hand, Kimani personally had known all three of the hotel owners for
more than five years. Bank procedure dictated that Kimani produce a “bazaar
report”2 on the three potential clients and the reports’ results had been most
favorable. The report had quoted other creditors describing the three participants as
“most satisfactory” and “A-1 businessmen.”

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2
A bazaar report consisted of telephoning several leading Malindi businessmen for their confidential
credit opinions of the owners of the Sapphire Beach.
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Exhibit 1

HOTEL BEDS AVAILABLE AND OCCUPIED BY AREA

1980 (000s BED NIGHTS)

Foreign Tourists
Number Beds Beds Bed as a % of
Of Hotels Avail. Occupied Occupancy Rate Business

NAIROBI 80 2,815.1 1,495.1 53.1% 58.6%

COASTAL BEACH
South 14 729.5 491.5 67.4% 86.5%

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North Mombasa 17 1,264.5 920.5 72.8% 91.9%

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Kilifi/Watamu 7 371.7 169.3 45.5% 89.2%

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Malindi/Lamu 15 447.6 228.4 51.0% 90.8%
Total 53 2,813.3 1,809.6 64.3% 90.1%

MOMBASA ISLAND 33 613.7 305.4 49.8% 40.4%

COAST HINTERLAND 11 285.2 120.5 42.2% 80.1%

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OTHER HOTELS 206 1,547.6 607.5 39.3% 54.2%

TOTAL KENYA 383 8,074.9 4,338.1 53.9% 68.0%

Source: Republic of Kenya, Central Bureau of Statistics

Exhibit 2

FORECASTED STATEMENT OF PROFIT AND LOSS

Years 1 to 3
(in Kshs 000s)

Year 1 Year 2 Year 3

OCCUPANCY RATE 65% 70% 75%

SALES
Accommodation 1,826 2,032 2,317
Restaurant 2,017 2,245 2,561
Bar 1,370 1,524 1,738
Other Miscellaneous 913 1,016 1,159
6,126 6,817 7,775

OPERATING EXPENSES 6,896 7,140 7,474

NET PROFIT (LOSS) (770) (323) 301

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Exhibit 3

SCHEDULE OF OPERATING EXPENSES IN YEAR 1

(in Kshs 000s)

Advertising 40
Alcohol and Beverages1 890
Automobile and Travel 75
Bank Charges 33
Bank Interest2 1,500
Depreciation 360

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Entertainment 24

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Food 1,109
Heat, Light and Power 480
Insurance 53
Linens and Housekeeping Supplies 146
Maintenance and Security 38
Management Fees 160
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Postage, Telex & Telephone 84

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Printing 144
Professional Fees 30
Repairs 350
Salaries and Benefits 1,340
Other 40

TOTAL 6,896

1
Alcohol and beverages were calculated at 65 per cent of bar revenues, food was calculated at 55 per cent of restaurant
revenues, and linens and housekeeping supplies were calculated at eight per cent of accommodation revenues.
2
Interest rate of 15 per cent based on the loan from the West German Bank.