CASE 10: 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 the 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 underutilized. 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 percent increment for the next two years. In order to accommodate the hotel’s expansion plan, Planet Karaoke Pub required only 70 percent 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 careful analysis of the offer from the Pub1.
That evening, Mike asked to meet with Kornkrit Manming, the hotel’s Financial Controller, to discuss the offer from Planet Karaoke Pub.
THE MUTUALLY EXCLUSIVE PROJECTS
Mike’s discussion with Kornkrit went as follows:
Mike: I see you have been busy. But I still need you to evaluate the offer from Planet Karaoke Pub for me, and to give me any positive or negative insights that you think are significant.
Kornkrit: No problem. I can present to you a detailed analysis within this week. But don’t you think we should provide more alternatives for the hotel owners to decide? Mike: That’s what I’ve been thinking. Perhaps we can create a pub by ourselves. Karaoke pubs are spreading fast in Thailand. A number of surveys have shown that they attract a lot of customers and tourists.
Kornkrit: That sounds like a good idea.
Mike: Please assess the projects carefully. You may ask your new assistant Wanida to help you. This is simple, isn’t it?
Kornkrit: I think the most difficult part is to estimate future profits and allocate overhead costs to each project. I’ll work on this first. Then I’ll ask Wanida to rank the projects according to their payback period and return on investment.
Mike: Good. I would like to have the results of your analysis next Monday. 1 Average return on investment = Average annual cashflow after taxes/Net investment 2
Kornkrit began his evaluation by reviewing the offer from Planet Karaoke Pub and estimating the revenues and costs associated with an alternative project, Beach Karaoke Pub. Planet Karaoke Pub
To make the space ready for lease, the hotel had to set up partitions and a small kitchen. Various estimates of the up-front renovation costs ranged between 770,000 baht and 1,000,000 baht. The costs would be depreciated over the life of the project using the straight-line method, with zero salvage value. Since the existing toilets, elevators, and carpets would be utilized to support this project, Kornkrit believed that a fair share of these overhead expenses should be allocated to the project. The pro rata allocation of the costs of these...