From: Albert, Andy, Becca, Chris, & Derek Consulting
Date:June 14, 2011
Re: Valuation of Potential Karaoke Pub Projects
Thank you for retaining AaBCD Consulting in the valuation of your future capital improvement project. There are two mutually exclusive capital improvement projects under consideration: lease under-utilized space to an unrelated third party, Planet Karaoke Pub, or invest greater capital to open and manage your own nightclub, Beach Karaoke Pub. Using the predominant valuation methods, we have analyzed the relevant quantitative and qualitative data over their useful lives. In our assessment, we discuss the strengths and weaknesses of each approach as well as their relative weights in determining the financial viability of each project. There are three underlying assumptions driving our calculations: 1) a 10.75% discount rate, 2) a 10% guest room erosion rate, and 3) the omission of irrelevant staffing costs (16% of sales) due to long-term salary contracts. We have determined that while both options are profitable, Beach is more so. However, before a final decision is made, more research into the qualitative aspects of these undertakings needs to be done; community footprint impacts and room revenue erosion rates must also be examined in more detail.
Relevant Economic Benefits (1)
In order to assess the viability of each project we must first determine the initial outlays and the relevant cash flows, assigning an appropriate discount rate based on the weighted average cost of capital. Taking the weight of equity (75%), the cost of equity (12%), the cost of debt (10%) and the corporate tax rate (30%), we have calculated and recommend a discount rate of 10.75%, which is much higher than the initial 5% estimated by Mr. Manming. From the initial outlays of both projects, we see a benefit of choosing the third-party project, Planet Karaoke. The initial investment in renovation of (700,000 to 1 million baht), is much less than that for Beach Karaoke (1.7 to 2.1 million baht), due to the added equipment costs associated with running and managing the night club. Using the previously calculated discount rate of 10.75%, the incremental cash flows for each investment are as follows: CF Planet: Y1) 516,250 Y2) 497,770 Y3) 522,060 Y4) 547,540 CF Beach: Y1) 887,312 Y2) 955,498 Y3) 999,386 Y4) 1,045,445 Y5) 1,125,052 Y6) 1,209,184
Project Comparisons (2)
Payback Period, Discounted Payback Period, Profitability Index, and Return on Investment:
In determining the value of capital projects, there are several valuation metrics at our disposal. In this case, we are presented with two mutually exclusive capital projects with different useful lives, and as such, there are certain criteria that are more useful than others. Payback period and discounted payback period both measure the number of years taken for future cash flows to cover the initial costs, yielding a good interpretation of risk and liquidity. We calculated Planet Karaoke’s payback and discounted payback as 1.49 and 1.65 years, respectively, and Beach Karaoke’s payback and discounted payback as 1.85 and 2.15 years, respectively. In general, discounting payback is more relevant, as it takes into account the time-value of money. Nevertheless, both methods fail to account for cash flows occurring after payback is reached, and therefore are not useful for our purposes since both investment horizons extend beyond their respective payback periods.
Profitability Index (PI) is more useful for ranking projects as it quantifies the amount of value created per unit of investment. Unlike payback and discounted payback, it also considers all cash flows of the project. We calculated a PI of 2.10 for Planet and 2.55 for Beach, which if taken alone, would suggest we invest in Beach Karaoke. Return on investment (ROI) is also useful as it measures the...