PHUKET BEACH HOTEL

Phuket Beach Hotel: Valuing Mutually Exclusive Capital Projects



Phuket Beach Hotel: Valuing Mutually Exclusive Capital Projects

Introduction

Phuket Beach Hotel has an opportunity to lease its under-utilised space to a karaoke pub and earn a rental income. Alternatively, the hotel could develop the unused space and create its own pub. The general manager of the hotel must decide which of the two capital projects to recommend to the hotel owners. The case presents sufficient information to build cash flow forecasts for each project and to rank the mutually exclusive projects using various evaluation criteria.

Case Analysis

Phuket Beach Hotel (PBH) has an underutilized space located on the second floor of the main building. Management has decided to consider investing in one of the two mutually exclusive projects which can effectively utilize the spare space of the Hotel. The first one is an offer made to them by Planet Karaoke pub to sign a four-year lease agreement and earn a monthly rental fee of 170,000 baht for the first two year and at a 5% increment for the next two years. The second opportunity would be to create their own pub to be called Beach Karaoke. To evaluate the two mutually exclusive projects, we have to consider the following criteria:

The present capital budgeting system ranks projects according to their payback period and average return on investment.

Ranking projects is often used in the situation of capital rationing. PBH might have had difficulties in terms of availability of cash, which would justify the use of the Payback method. However, it's an old system that hasn't been revised for years, now conditions have changed. Liquidity of the projects is not essential, since the hotel has enough cash on hand to finance the projects without the need to take on additional debt.

The PBH Financial Controller Kornkrit felt that past proposals were rejected because the discount rate used was too high. In order to make the valuation as accurate as possible, we have to find a proper discount rate which can reflect the reality.

There are also some qualitative factors which are difficult to quantify.

(a) Initial cash flow

At the very beginning, the following costs have been incurred:

Year 0

Cost of machines

4,000,000

Installation cost 4,000

40,000

Working capital (i.e. inventory, )

250,000

4,290,000

(b) Annual after-tax cash flows

First, we need to determine the annual operating income of the firm (year 1-8) as follows:

Sales

5,000,000

Production cost

-1,000,000

Marketing expense

-2,000,000

Rent

-500,000

Operating income

1,500,000

Next, we need to figure out the depreciation. ...