2. Valuing Mutually Exclusive Capital Projects
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Introduction
Phuket Beach Hotel has an unused space located at the second floor of the main building.
Planet Karaoke Pub made an offer to the general manager of Phuket Beach Hotel, Mike
Campbell that requires 70% of the unused space which equals to 3,000 square feet. This would
allow the hotel to keep the remaining space for the creation of an alley two years later. Besides,
the utility and other expenses are covered by pub. After meeting with Kornkrit Manming
(Financial Controller, Phuket Beach Hotel), Mike was asked to make a project analysis for the
offer as well as an alternative plan- build their own pub. Now general manager Mike Campbell
has two choices in front of him: rent the space to Planet Karaoke Pub, or build the Beach
Karaoke Pub by Hotel itself.
Phuket Beach Hotel has a weighted cost of capital of 10.75%. With a fair balance of
multiple aspects and careful consideration, it is better to choose Planet Karaoke Pub for the
unused space.
Analysis Section
What are the relevant cash flow associated with each project?
(Note: the Excel spreadsheets shown below contain the analysis of each of the project with only
one possible scenario, i.e. with patronage loss of 12.5% and lowest initial outlay. The data from
other possible scenarios are shown and discussed in sensitive analysis part.)
Planet Karaoke Pub is expanding fast in Thailand. Their offer with the rental of unused
space in Phuket Beach Hotel contains:
1. A monthly rental fee of 170,000 baht (equal to 2,040,000 baht per year) for the first two
years, then there is a 5% increase for the next two years (2,142,000 baht for third and fourth
year).
2. Four year project life with upfront costs range from 770,000 baht to 1,000,000 baht,
which contributes to the initial investment costs in five ranks in sensitive analysis: 770,000 baht,
827,500 baht, 885,000 baht, 942,500 baht and 1,000,000 baht.
3. Patronage loss (loss of customer) is shown as a percentage loss of net room revenue. The
patronage loss can be as high as 25%, ranging from 0 to 25%. The patronage loss percentage is
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also divided into five ranks with equal interval: 0, 6.25%, 12.5%, 18.75%, 25%. If patronage loss
rate is 12.5%, the loss amount is 1,650,000 baht.
4. Pro rata allocation of existing overhead expenses amount to 55,000 baht which is
excluded from cash flow as an non-incremental cost, because this cost would happen whether
choose this project or not. Another 10,000 baht of increase in repair and maintained is marked as
“relevant expenses”.
5. Straight line depreciation method is applied on the cost with zero salvage value. Each
year’s depreciation is calculated by dividing initial investment cost by 4 year. For example,
annual depreciation is 192,500 baht with an initial investment of 770,000 baht.
Beach Karaoke Pub is the hotel-owned pub, as an alternative project to Planet Karaoke
Pub. The cash flow associated with this plan contains:
1. Initial investment ranges from 800,000 baht to 1,200,000 baht. Other capital investment
is assumed to be 900,000 baht. This gives a total capital cost ranges from 1,700,000 baht to
2,100,000 baht. Five ranks are equally divided: 1,700,000 baht, 1,800,000 baht, 1,900,000 baht,
2,000,000 baht and 2,100,000 baht.
2. Revenue is expected to be generated from 50% of walk-ins and 50% of hotel guests. This
counts to the total revenue when evaluating the project.
3. Patronage loss is shown as a percentage loss from net room revenue. If patronage loss
rate is 12.5%, the loss amount it 1,650,000 baht.
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4. First year revenue is assumed to be 4,672,000 baht with 64 covers per day and an average
check of 200 baht. It is expected to grow 5% every year, so the second year is 1.05 times of
4,672,000 baht, which is 4,905,600. The revenue continues growing until the end of investment
period.
5. Food and beverage costs account 25% of sales, salary expenses count 16% of sales and
other operating expenses account 22% of sales. Salary expense is excluded from incremental
cash flows. Reassignation of job position is not treated as incremental Because Beach Karaoke
Pub can recruit internally and the salary of excess manpower will not change with different job
position. Besides, Beach Karaoke Pub will pay 10,000 baht per year as a repair expense.
6. Straight line depreciation method is applied on the cost with zero salvage value, and
annual capital expenditure equals the amount of depreciation. When the total initial investment is
1,700,000 baht, the depreciation is divided into six years which equals 283,333 baht per year.
Valuation Method
After identifying relevant and incremental cash flow associated with each project, the
next step is to compare and evaluate the two projects. The rationale of evaluation is to find the
project with larger return in a shorter period of time. Therefore, some indices and ratios shall be
used to evaluate the two mutually exclusive project.
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Because the two projects have wide range of initial investment and variable patronage
loss, the ratios calculation and comparison are based on the scenario that both of the two projects
have their own initial investment and the same patronage loss of 12.5%.
1. Payback period
The payback period measures the time required for the invested amount to be repaid with
the generated cash flow. This criterion along with the second one (discounted payback period) is
commonly used to evaluate the time it takes for the investors to recoup the cost. The payback is
one of the criteria that most of investors care about. In this case, Planet Karaoke Pub has payback
period of 2.46 years and Beach Karaoke Pub has 3.84 years. In this sense, Planet Karaoke Pub is
competitive because it allows investors to be paid back quickly.
2. Discounted payback period
While the first criterion provides information about how quick the investors could
recover their cost, the second one- discounted payback period gives us a more accurate way to
measure the payback time by taking time value of time into consideration. It is because the cash
flow generated in the future worths less than it does today. Planted Karaoke Pub and Beach
Karaoke Pub have discounted payback period of 3.01 years and 4.95 years, respectively. The
first project still outperforms the second one but both of them require longer time for investors to
be repaid.
3. NPV and IRR
Net present value is the difference between the investment and the sum of present value
of cash inflows. Projects with positive NPVs create value for companies or investors. To
measure mutually exclusive projects, we choose the project with higher NPV, which is 373043
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bahts given by Beach Karaoke Pub. IRR is the rate at which the sum of cash inflows equals the
initial investment. Higher IRR allows projects to be more capable of generating positive NPV.
The project of leasing space has high IRR.
4. Profitability index
Profitability index measure the value created by each unit of investment. It reflects the
efficiency of the use of investment. In this case, the two projects have nearly the same PI.
By using the criteria above, we can evaluate the two projects. Planted Karaoke Pub is
preferable if we care about the payback time; The alternative project sounds better if we need
higher return. However, the two projects have unequal life which cause conflicts between NPV
and payback period. For example, an investor who wants his money back quickly may choose
the project with shorter payback period without any hesitation. Another project with higher NPV
and equivalent annuity may be rejected because of longer payback period. Actually this project
could provide more liquidity and return for the investor. In order to evaluate the projects with
different lifetime, we add two more criteria.
5. Equivalent annuity
Equivalent annuity is the constant payment over the project’s life if the project was annuity. The
usefulness is that EA approach eliminates the consideration that investors can reinvest after a
shorter project. The equivalent annuity approach provides a comparison relevant to time.
6. Average return on investment
Average return on investment is the ratio of average cash flow generated each year and the initial
outlay. This index provides better perspective on how profitable the project is each year given an
average bases. It works the same as equivalent annuity but it does not take TVM into
consideration.
Determination on cost of capital
Although we were suggested using interest rate of 5% as discount rate, we still think
using 5% is inappropriate because it is more risky to invest money in the projects instead of the
bank. The money used for the projects comes from two sources: equity and debt. The equity
owners and debt holders require higher return so that their average expected return shall be the
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opportunity cost of the projects. Therefore, the discount rate should be weighted average cost of
capital rather than interest rate. In this case, the WACC is 10.75%.
Sensitivity Analysis
When there is no room revenue decreases and with the minimum amount of initial
investment, Planet Karaoke Pub has the lower Net Present Value than Beach Karaoke Pub does.
But Planet Karaoke Pub loses less when the extreme scenario (25% lost in room revenue and the
initial investment cash outflow is maximized) is applied compared to Beach Karaoke Pub.
The Net Present Value on Planet Karaoke Pub starts turning into negative when room
revenue is decreased by 12.5% and the initial investment outflow is equal to 1,000,000 baht. In
the contrast, The Net Present Value on Beach Karaoke Pub starts turning into negative only
when room revenue is decreased by 12.5% and the initial investment outflow is larger or equal to
2,000,000 baht.
The fact indicates that Planet Karaoke Pub is less sensitive than Beach Karaoke Pub in
the changes of loss on room revenue and initial investment cash outflows.
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Key Value Driver Analysis
The key value drivers for Karaoke industry are mainly two parts, which are extraordinary
hardware and high-quality service. As for hardware, a Karaoke company could expand its song
base to include majority of songs in music industry so that customers would not feel
disappointed when their favorite songs are not in the song base. Although buying song’s
copyright is not a small cost, company should have a smart selection criteria adhere to sense of
customers. Moreover, Karaoke company could also build various theme rooms to enhance
customer experience and better differentiate itself from the whole market. And the theme of the
room could be determined by customer surveys or in-depth research using statistical techniques.
This strategy would leave customer a deep impression about the company brand which is a good
way of advertising. As for high-quality service, Karaoke company could diversify its dining
options so customer would stay longer as they have more choices to enjoy. In addition, the air
quality in Karaoke rooms has always been a huge problem to be considered because the rooms
were sealed and many people would smoke inside of the room. If Karaoke company utilized
advanced air ventilation system to eliminate harmful elements and enhance the concentration of
oxygen in the air, it will also be a competitive advantage for the company.
Recommendation
For this case, we would like to recommend board of directors to lease their space to
Planet Karaoke Pub rather than build its own Beach Karaoke Pub, although neither of the two
projects could dominate another one. However, leasing out space to Planet Karaoke Pub still
sounds better. Initially, the payback period for leasing option is much shorter than that of
building option. Moreover, the average return on investment of leasing option is also higher than
building option and this indicates the actual increase of cash flow. Internal rate of return and
sensitive analysis also suggest that Planet Karaoke Pub is less sensitive to the change of discount
rate, unexpected loss and initial outlay. Although the NPV of leasing option is lower than
building option, this could be due to inadequate specified period of time which does not
necessarily reflect the actual present level of cash flow. In addition, the tradeoff between higher
NPV and shorter project life should also be considered. Leasing option provides shorter life
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which allows Phuket Beach Hotel to make another investment after the pub project. Under the
circumstance that neither of the two projects could be dominated, adopting a shorter plan may
bring more liquidity and flexibility to Phuket Beach Hotel. In conclusion, we recommend board
of directors to undertake the leasing option without hesitation.
