Phuket Beach Hotel

1. HKU145
08/15/01
Phuket Beach Hotel: Valuing Mutually Exclusive
Capital Projects
Mike Campbell. General Manager' o(Phlikel Beach Hotel, paced his orficc and cOllsidered lill
otTer made by Planet Karao~e Pub. Planet Kar-anke Pub was expandi ng fast ill Thai land. II
was looking for a venue ill Patong beach area for sening up ,,lIlother oUllet and was eyeing an
lITlll~ed ~p<Jce owned by the Hotel. At thi poin!. the space was located on the second floor of
the main bui Idillg and was very much under-util ised. It was reserved for the construction of
an alky linking 10 a new wing for tile hotel, which would Ilot be completed Inti I IwO years
laler,
Planet K(lJ(loke rub offered 10 ~ign a four-year lease agreement with the hotel for renti ng pm1
of the unused space, It proposed to pay:
• a m011thly rental fee of 170,000 baht for the fi rst two years: and
• thereafter. a 5% increment tor tile next two years.
In order 10 accoIII modale Ihe holeI's expanSion pian, PIanet Karaokl" PLJ b re'J lJ ired onIy 70%
of tile unused space, which had a size of 3,000 sq. feel. rhis would allow the hotel to keep
the rcm;1in ing space for the creation of an alley two years later,
11 was envisClged thm the proposed pub would not affect the hOlerS future expansion plan.
Nevertheless, Ivl ike was sti II a bi1 perplexed about the decision facing him. Sirni lar
development proposals had previously been rejected by the board of directors, One of lhe old
proposals, wh ieh involved converti ng the space into a cigar and champagne bar, had been
rejected by the board because it required a long payback period. Another proposal for the
creation of a spa was discal'ded due to its 101 r'et urn 011 investmenl. Given lhat the present
carital budgeling system ranked projects according 10 payback period aiJd avemgc ret LJI11 OIl
iI1veSlmCI1I, M ike decided to seek a careful ;1llalysis of the oller from the Pub,'
That evening, Ivlike Clsked to meet with Kornkrit Ivlanming, the hotel's Financial Controller,
to discuss the orFer from Planet Karaoke Pub,
140r,. /-10 I,re/Jared II"s ,,'of? Wide! llit ,tlljJtITIJI"n (J) 1',-,,( ,,, Iian CliOli and 1-',-,,( Ao Wang fiJI' (ias.' d',lnJ,;5IrJn
The /inns and Ihe mdn'tduals '" II"s c"s~ a,-e /ic'IIO",,1 7'lIiS cas~ 1.1 Iwl "'te"dal In I'hm" ~fr~('/tV<' or me(jer;llve
Jnrndl'n& (d dI...'Cf,llD/i or nU,I"lt/c,·,' prnces,t','
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(iXX! o/Nol1g A.-o'1?­
('()f''I'If!,h/~~ lO(! I rh" l/iIIHn-iIl' l!f / /ong An',f,. .'01'(111 nl illI.ll",hlICOIIO/I 11/0,1' iJ~ rel'iYJduced 01 IUIII,WII/tet! II!
(Un j(Jrm OJ' tn (Ull' /}Icun,' - f'h.'clrOJ7H, rnfchamcal j)h()/()c(j{J"'ln~ I"f!conling (JI' o!htrll 1St' (l'Ic/wilu?) ,Jw I"fernef)
- 1'J,hr)l{J rhe pcrml."Si(Jf1 uf Thl' (;nn'cn if)' (~f I!ong ;""ung
,lief (Ii lOS!'

2. 01f108C Phukel Beach Hotel Valuing MUlually Exclusive Capital PrOJecls
The Mutually Exclusive Projects
Mike's discussion with Komkril wenl as follows:
lv/ike. J see you have been busy. But I stili need yOli to eva/llale the offer Fum Plam,l
Karaoke Pub ./<,1' me, and 10 give lIIe any POSI//Vf or m!gOllve in,nghls Ihol you lhmk arC'
sigl1!!iconr
Korllkr;/ [I/o problem J can prl!Sl!nt /(J -"Oil (/ deloiled analysi.s ll'/lhin Ihls week BUI don 'I
you Ihlrlk we .hould proVIde ilIOn; aliemollves/or Ihe hOle! owner<; to decide?
fl,1ike: Tllm's ,,l1ot j've h.:en rhinking Perhaps Y1Je Cim creole a pub by ourselves, Karaoke
puhs are spreadll1g fasl In ThOlland -4 illllll!Jer o{surveys have shown Ihal Ihey aI/roC! a /01
0/CUSTOmers and tounSls
f(ornkrit: That SOl/lids like (! sooJ idea
Mike: Ptease ass"s,' Ihe project' curejirlh' J'OIl 11111)' ask your 17('1' aSslstaill IFollida 1(1 helf)
Y(J/I. Tills 1. simple, 1.1'/1" il~
Kornkrit I think the most difficult pari I:; 10 estimOie future profi/~ and a/foccile overhead
costs 10 Ihe each proJecl I'll lVork on Ihis firsi. Then !'if ask If'anida 10 rQnk the projeC/.'
uccordmg to Ilu!ir fJilyhack period Gild return on Inveslmenr,
ll1ike. Cood. Jwould like 10 have Ihe reslI/{s o(your analySIS nexi /vfonday
Kornkrit's Analyses
Komkrit began his evaluation by revi~wing the offer from Planet Karaoke Pub find estimating
lhe revenues and COSIS associated wilh an altemative projecl. Beach Karaoke Pub.
Planet Karaoke Pub
To make the space ready for ICilse. the hotel had to set lip pat11l10nS and a. '5l11all kitchen.
Various eslilllmes of the Ll p-fron! renovOl ion costs ranged belween 770.000 hallt and
J .000,000 baht. The costs would be depreciated over thc life of the project llsing the straight­
line melhod. with zero s<llvage vellae. Since the e:-.isling toilets, elevators and carpelS would
be uti tised to support this project. Korncrit bel ieved thaI a fair share of Ihese overhead
expenses should be allocated to the project. The pro rata allocation of the costs of these
facilities, b<lsed on the l100r area of the space used lor the project, amounted to 55,000 baht.
DLl~ to the foreseeable incre.i1se in activity, Korncrit would like to charge this project for an
incr~flSc in repair ilnd maintenance C0stS of 10.000 baht per annum. The pub wotlld pay all
utility and other expenses,
Beach Karaoke Pub
The project would require an up-frollt investment ranging between 800,000 and 1.200,000
baht, This represented the cost of a modem-style decor. Other capital investment, including
ch8irs. bar trtbles. kitchell set- up and karaoke equipment, would ilillount to 900.000 bah t,
Kornkrit epeCled revenue to be gencrflk-d 50% from walk-ins and 50% from hotel guests,
Estimated total sales would be 4,672.000 baht for the first year of opcmlion. Kornkril arrived
at this figure by assuming all average of 64 covers per day w ilh an average check of 200 baht.
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3. Q11108C Phukel Beach Holel: Valuing Mutually Exclusive Capiial Projects
With a scating capacity of 32. the puh haclto tum tables at leasltwice a day. Operating hours
of the pub would be from 5:00 p.m. (0 midnight.
The projected length of the proiect W<1S six years. Sales were e.pccted [0 grov 31 5% per
annum in terms of the 3verage check. Growth in cover> would be limited due to limited
Cit pilCity.
Komkrirs estimates for operating costs were as follows:
Food and beverage costs 25% of ales
Salaries 16% of s<'lles
Other operating expenses 22% of sales
Depreciation: equipment & furniture Depreciated equally over the life of the project
using the straight-line method: with I..ero salvage
value at the end
A nl1l1al capital expenditure Equalled depreciation
Korncrit estimated thm salary expenses would accoulH for J6% of saks. StafT could be
recruited intemally because the hOlel had excess manpower at this poin. The ehcess starr had
long-IeI'm conlracts with the hotel and were kept in order to meet the demilnds of the growing
business. Repair<; and maintenance costs wne eSlimated to be lile same <1S for Planel Karaoke
rub.
Capital Structure
Phukel Beach Hotel hilS a capital structure consisting of 75% equity and 25%) debt. The debt
consisted entirely of loans from Siam Commercial Bank bearing an interest rate of 10%,. The
hotel owners' cost of equity was 12%. The corporate tax rate in Phuket W<lS 30%,.
The Test
Kornkrit W(lS quite happy with his estimates. 1l10Ugh it had taken him more time than he had
originally though. Now, he had all the figures he needed. The next step wa~ to rank the
projects according to the criteria Set by the hotel's capital budgeting system. He saved his file
(llld sent it Lo his new a istant Wanida, a recent graduate from Thammasat Universily. "Here
you go. Wanida. This will tesl what you learnt ill business school!," he though.
The following is an excerpt from an ema;I 1'1"0111 Kornkrit:
To: Wanida Daoruang <wanida@be(lch-hotel.phukct>
From: KOl'llkrit Manming < komkrit@beach-hotel.phllket>
Suhject: Rank ing Capital PI'ojectS
Dear Wanicla,
.. _! have pravided you with a[I the figures you need for the projeCI ion of fut llrc profi ts for the
two projects. Please evaluate the projects on the basis of their payback period and (heir
average return on investment. Note that future profits should be discounted at 5%. This is the
interest rate we eamed from our time deposits at Siam Commercial Bank. I believe some of
our old proposa15 were rt:iected because we used a discount rate that was too high. Since we
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4. 01/108C P/1uket Beach Holel Valuing Mutually Exduslve Capital Project
have en ugh cash on hand to finance the projects. I don't thin" we hould ta"e inlo account
the CO.l of debt hen e tim3.ting the di-c unt rate.
Let me "no ifynu have an) qucstiow
Regard,
Kornkrit Manming
'" * "
Wanida pondered the detail. of th projec he thought there was something wrong irh the
h tel's capital budgeting sy tem. whi h had n t been re iewecJ for many ea . The existing
.) 5t m ranked proje ts a cording to their a erage return on inve..tmem and payback period.
It s emed to her that som thing was mined in the anal i.
Wanida was al a aware that certain aspects of the in e'tment decisl n were difficult 10
quanti!}. The Chief. ecurity OmC!;;r hall e. pre ed hi concern' and displeasure over the
security pr blcms that a karaoke pub might bring. He wa rried that th pub might attract
unwelcome guests fr m utside. This might be a negati e (aCt r for the pub in terms of
attracting lOurist tra ell ing ith children. Wanida thoughr the) accounted for 25% of the
LOtal patronage [se Table fI r the projection n net room re enue for the next si years].
Table
Projccti n of et Room Revenue (in Baht)
(= Room ale' - Room Operatin E 'pen'c )
Year I 2 3 4 5 6
Net room
revenue
13,200,000 13,464.000 14.137.000 14,844.000 1·.140.000 15,443,000
The follO ing are th questions that Wanid consid red:
1. What are the relevant ashflow as ciated with ea,;!l project?
What criteria should bc u ed to evaluar Ihe proje ?
3. How can I compare project. with different live '?
4. What di- ount rate h uld be u ed? Wanida thought the di count rate of 5% as to 10.
Investing in the tv,; projects Va ertainly more risk) than put1ing the money in the bank.
5. What arc the key value drivers and h w do Ihey affect the attractivcnes of the project ';
6. Which investment proje I should be re ommended to th board or dire tor?
When anida g t home. she had a tal" with her hu band about the propo"ed project. Her
husband. 3. s cial wor"er. r minded her of the increasing number of drug arrests in karaoke
pUb5. He suggested that n., a go d member of th communi!). the h lei h uld not be
iO' 01 'cd in thi. ty pe or project.
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