Bridgehampton Shores Inn:

Mutually Exclusive Project Comparison

Finance 203 – Managerial Finance

Dr. Anoop Rai

Fall 2012

Capital Budgeting Case Study:

Bridgehampton Shores Inn: Mutually Exclusive Spa Projects

Introduction

Bridgehampton Shores is an Inn located on the Eastern Inn of Long Island. It typically caters to families looking to vacation in the area and take advantage of all the East End has to offer. Currently, Bridgehampton Shores Inn has 10,000 square feet of available space for lease. Potentially, 1/5 of the available space will be used to build a pathway for connection purposes to their existing facilities and the remaining 4/5 may be rented to a third party. Suncoast Spa, a Californian based company who is currently expanding in the Northeast offers to lease the unused property from Bridgehampton for 4 years. Under the terms of the lease, Bridgehampton will be responsible for the capital expenditure needed to make the space suitable for leasing. Suncoast will be responsible for any other renovation costs required for their operation plus all the other utilities and operating expenses. Theoretically the proposed lease seems like a positive proposition for Bridgehampton. However, Marie O’Donnell, Bridgehampton’s General Manager has seen similar proposals rejected by the board in the past. Working with Jim Naruda, the Financial Controller, they discuss an alternate plan to develop a Spa internally. Jim suggests that the opportunity is ripe to expand into the Spa business as the East End has become a sought after destination all year round and not just during the summer season. They decide to conduct an analysis to determine if it would be more beneficial to build a Spa themselves or lease the space to Suncoast. The following report summarizes and clarifies the comparison and makes a recommendation as to which course of action to follow. The report is based on the lease terms as well as the estimated costs and assumptions provide by both Jim Naruda and his assistant Isabel Ayarza. All initial investments will be depreciated on a straight-line basis with a zero salvage value. Methodology of Comparison and Explanation of Exhibits:

In order to make our assessment, we utilized the Discounted Payback Method, the Internal Rate of Return (IRR) and the Equivalent Annualized Net Present Value (EANPV) as criteria in conducting the financial analysis. The discounted payback period method is defined as the number of years it takes for the initial investments to be “paid back” by the present value of incoming cash flows, or the amount of time needed to break even on the project. By adjusting for the present value, the analysis becomes more valuable as it overcomes the weakness of the traditional calculation of the payback period which ignores the time value of money. Unfortunately this method ignores the future cash flows projected by the project and should be supplemented by other methods such as the Internal Rate of Return (IRR) method and the Equivalent Annualized Net Present Value Method of (EANPV). For mutually exclusive projects as this one is, meaning the Board may only proceed with one or the other project, IRR may also present issues. It has been found that returns may potentially be misleading when working with mutually exclusive projects and may lead to an incorrect conclusion. For example the IRR may be higher if one project is accepted, but the total Net Present Value (NPV) of a project may be higher based on the discount rates or the required return. Basically when using the IRR method unrealistic assumptions about the reinvestment rate may occur. Further, the basic purpose of any investment is to create value for the shareholder so a higher NPV should always be considered over relative return rates. In addition, since the IRR is determining when the NPV is 0, in some cases multiple rates of return may...