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BMD5301 Group Case Analysis 

Phuket Beachside Hotel: Valuing Mutually Exclusive Capital Projects

Mike, General Manager of Phuket Beachside Hotel (PBH), paced his office and considered an offer made by Good Time Pub (GTP). GTP was expanding fast in Thailand. It was looking for a venue in the Patong beach area for setting up another outlet, and was eyeing an unused space owned by PBH. At this point, the space was located on the second floor of the main building and was very much under-utilised. It was reserved for the construction of an alley linking to a new wing for the hotel, which would not be completed until two years later.

GTP offered to sign a four-year lease agreement with PBH for renting part of the unused space. It is proposed that:

a monthly rental fee of 170,000 baht will be paid for the first two years; and
thereafter, a 5% increment for the next two years

In order to accommodate the hotel’s expansion plan, GTP is allowed 70% of the unused space, which has a size of 3,000 square feet. This will allow the hotel to keep the remaining space for the creation of an alley two years later.

It is envisaged that the proposed pub would not affect the hotel’s future expansion plan. Nevertheless, Mike is still perplexed about the decision facing him. Similar development proposals have previously been rejected by the board of directors. One of the old proposals, which involved converting the space into a cigar and champagne bar, had been rejected because it required a long payback period. Another proposal for the creation of a spa was discarded due to its low return on investment. Given that the present capital budgeting system ranked projects according to payback period and average return on investment, Mike decided to seek a careful analysis of the offer from GTP.

Mike asked to meet with Kelly, the hotel’s Financial Controller, to discuss the offer laid out by GTP, and to think of possible alternatives. One conclusion reached, was that PBH can set up the pub themselves, instead of having an external party do this. To aid the decision-making, Kelly provides the following analyses:

Good Time Pub

To make the space ready for lease, the hotel has to set up partitions and a small kitchen. Various estimates of the up-front renovation costs ranged between 770,000 baht and 1,000,000 baht. The costs will be depreciated over the life of the project on a straight-line basis, with zero salvage value. Since the existing toilets, elevators and carpets would be utilised to support this project, Kelly believes that a fair share of these overhead expenses should be allocated to the project. The pro rata allocation of the costs of these facilities, based on the floor area of the space used for the project, amounted to 55,000 baht. Due to the foreseeable increase in activity, Kelly would like to charge this project for an increase in repair and maintenance costs of 10,000 baht per annum. The pub will pay all utility and other expenses.

Phuket Beachside Pub

The project requires an up-front investment ranging between 800,000 and 1,200,000 baht. This represents the cost of a modern-style décor. Other capital investment, including chairs, bar tables, kitchen set-up and karaoke equipment, would amount to 900,000 baht.

Kelly expects revenues to be generated 50% from walk-ins and 50% from hotel guests. Estimated total sales would be 4,672,000 baht for the first year of operation. Kelly arrived at this figure by assuming an average of 64 covers per day with an average bill of 200 baht.

With a seating capacity of 32, the pub will have to turn tables at least twice a day. Operating hours of the pub will be from 5pm to midnight.

The projected length of the project is six years. Sales are expected to grow at 5% per annum in terms of the average bill. Growth in covers would be limited due to limited capacity.

Kelly’s estimates for operating costs are as follows:

Food and beverage costs at 25% of sales
Salaries at 16% of sales
Other operating expenses at 22% of sales
Depreciation of equipment and furniture will be on a straight-line basis over the life of the project with zero salvage value
Annual capital expenditure will equal depreciation

Kelly estimates that salary expenses will account for 16% of sales. Staff can be recruited internally because the hotel has excess manpower at this point. The excess staff have long-term contracts with the hotel and are kept in order to meet the demands of the growing business. Repairs and maintenance costs are estimated to be the same as for GTP.

Capital Structure

PBH has a capital structure consisting of 75% equity and 25% debt. The debt consists entirely of loans from Thai Commercial Bank bearing an interest rate of 10%. The hotel owner’s cost of equity is 12%. The corporate tax rate in Phuket is 30%.

Evaluation

With the estimates, Kelly approached her assistant Walter and instructed him to prepare an evaluation of the options on the basis of their payback period and their average return on investment. In addition, Kelly highlighted that any discounting should be at a rate of 5%, which corresponds to the interest rate that is earned from time deposits at Thai Commercial Bank. Furthermore, Kelly believes that past projects were rejected as the discount rate was too high, and given that there is sufficient cash on hand to finance the projects, she feels that the cost of debt should not be taken into account when estimating the discount rate.

Walter thinks that there is something wrong with the hotel’s capital budgeting system, which has not been reviewed for many years. The existing system ranks projects according to their average return on investment and payback period. To Walter, it seems that something is omitted in the analysis.

Walter is also aware that certain aspects of the investment decision are difficult to quantify. The Chief Security Officer has expressed his concerns and displeasure over the security problems that a pub might bring. The worry is that the pub might attract unwelcome guests from outside. This might be a negative factor for the pub in terms of attracting tourists travelling with children. Such tourists account for 25% of total patronag.

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