Valuing Mutually Exclusive Capital Projects
- 1. Baozheng Ge Ke Liu Jiayao Qi Phuket Beach Hotel Case Analysis Corporate Finance F3, 2015
- 2. Valuing Mutually Exclusive Capital Projects 1 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
- 3. Valuing Mutually Exclusive Capital Projects 2 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 years 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.
- 4. Valuing Mutually Exclusive Capital Projects 3 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.
- 5. Valuing Mutually Exclusive Capital Projects 4 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
- 6. Valuing Mutually Exclusive Capital Projects 5 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 projects 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
- 7. Valuing Mutually Exclusive Capital Projects 6 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.
- 8. Valuing Mutually Exclusive Capital Projects 7 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 songs 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
- 9. Valuing Mutually Exclusive Capital Projects 8 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.