I. STATEMENT OF THE PROBLEM
This is an assessment of the different costs and benefits of two mutually exclusive capital projects involving the use of an underutilized space located on the second floor of the main building of Phuket Beach Hotel (PBH). The first project, Planet Karaoke Pub (PKP) offered to sign a four-year lease agreement with (PBH) while the second project, Beach Karaoke Pub (BKP), is a pub the PBH itself, plans to put up and to operate for six years. PKP proposed to pay a monthly rental of 170,000 baht for the first two years with a 5 % increment for the next two years. Renovation costs for PKP ranged between 770,000 and 1,000,000 baht. PKP will be charged 10,000 baht per year for repair and maintenance costs and it will also shoulder all utility and other expenses.
BKP, on the other hand, expects to generate 4,672,000 baht in sales for the first year, which is projected to grow at 5 % per year. BKP would require an upfront investment ranging between 800,000 and 1,200,000 baht and other capital investment amounting to 900,000 baht.
The assessment might also have to consider the concerns of Wanida, the assistant of Kornkrit Manming, PBH’s financial controller. Her concerns are PBH’s flawed capital budgeting system, which had not been reviewed for many years, that evaluates projects based on payback period, average return on investment and a discount rate of 5 % that Wanida finds too low. Another concern is the qualitative factors that are difficult to quantify, such as security concerns that would decrease the attractiveness of the hotel to tourists travelling with children who, Wanida thinks, account for 25 % of total patronage.
The objectives of this evaluation therefore are:
1. To determine for each of the projects the initial outlay, relevant incremental cash flows and the appropriate discount rate to use for discounting the incremental cash flows;
2. To rank each project based on various measures of investment attractiveness and to identify which criterion is the best;
3. To verify whether or not the two projects are comparable based on the standard NPV measure given that they have unequal lives and to identify an alternative method for comparison;
4. To find out the sensitivity of the projects’ rankings to changes in the discount rate and in any of the key value drivers; and,
5. To recommend which project should the hotel undertake.
1. PBH has enough cash on hand to finance either projects without the need for the hotel to take on additional debt and therefore, the capital structure of PBH will remain unchanged and either project will not have liquidity problems.
2. Either project will not affect the hotel’s future expansion plan and will not cause any social problems to the community.
3. Phuket, as a tourist destination, has recovered from the devastating effects of the 2004 tsunami and has continued to derive much of its income from tourism.
4. Kornkrit Manming and Wanida are both knowledgeable in the techniques for evaluating capital projects and that their assumptions and projections are correct.
III. CASE ANALYSIS
A. Discount Rate, Initial Outlay and Incremental Cash Flows
1. Weighted Average Cost of Capital = %Equity x Rate + %Debt x Rate x 1-tax rate
WACC = [75 *.12] + [25*.10* (1-.30)] = 10.75%
Discount rate = discount factors at 10.75% WACC
2. Net Income
The Income Statements, Cash Flows, Net Present Value, Internal Rate of Return and Payback Period are contained in the following Annexes:
Annex A – Project 1: PKP with initial investment of 700,000 baht Annex B – Project 2: PKP with initial investment of 1,000,000 baht Annex C – Project 3: KBP with initial investment of 800,000 baht Annex D – Project 4: KBP with initial investment of 1,200,000 baht
The summary of indicators is contained...