Chapter

27

Lttnger-Rttn Decisir-tns Cupital

Budgeting 865

Case 27-3

Projects*
phuket Beach Hotel: Valuirrg Murually Exclusive Capital
Phuket Bea'l'
Mike Campbeli, General Manager of
an ofl'er made
considered
Hot"t, pu""a his oilice and

was ex-

Karaoke Pub' Planet Karaoke Pub

a venue in
^r.t
p'"ra"g ftti in Thailand' It was looking for
outlet'
another
up
setting
iir. nu,lng beach area for
Hotei'
bvlhe
owned
space
;;;;;t Jyelng an unused
second
the
on
located
was
At this point, th. space
undern""t irr. main building and was very mtlch of an
"f lt was reserved for the construction
utilised.
hotel' which would
alley Hnking to a new wing for the
later'
years
two
not
- te completed until
a four-year
Planet Ka.aoke Pub offered to sign
part of the
renting
for
hotel
with the

UV pf

1"ur. ug...-ent
unused sPace. It ProPosed to PaY:

with Kornkrit
That evening, Mike asked to meet
to discuss
l4un*ing, the f,otel's Financial Controller'
the offer from Planet Karaoke Pub'

THE MUTUALLY EXCLUSIVE PROIECTS

Mi1ie .

il*tsion

with Kornkrit went as follows:

you
you have been busy' But 1 sti1l need
for
Pub
ihe offer from Planet Karaoke
to
insights
"rutu,,,.
me, ancl to give me any positive or negative

Mikc: i

see

that You thiriii are significant'

a deKornkrit: No prlbiem" I can present to you
think
you
don't
But
tailed analysis withrl this week'

the hotel
we should provide mcfl- alternatives for
owners ro decide'?

Mike: That's what I've been thinking'

two Years; and

the next two
thereafter, a 5 percent increment for

shown
iog futt i"fnuiland' Anumber of sris'eyshave
thit they attract a lot of customers ani tourists'
Kornkrit: That sounds like a good idezr'
may
Mike: Piease assess the projects carefully''r'ou
'lllis
is
you'
assistant Wanida to help

years.

plan'

In order to accommodate the hotel's expansion the

piur.t t<urooke Pub required onl.v 70 percent of
sq' feet. Thts
un*r.a tru"., which had a size of 3'000
space for
*oufO ufio* tt'r" hottl to keep the remaining

creation of an alley two years later'

the
"'--I;;;t
would not
envisaged that tire proposed pr-rb
plan'.Nevertheaffect the hotelis fttture expansion
d5cisr,ol
i"rt, noir." was sti1l a bit perplexed about.the prevthad
proposais
iu"i"g r',i*. Similar development
by the board of directors' One of

U.",

rejected
"-tiy
which involved-converting the space
proposuls.
ifr.
"fA
been rejected by
inio u ogui and champagne bar' had
payback period'
ifr" U""tA because it required a long
was disof
ir"ifr"t proposal for the creation a spaGiven
that
investment'
carded arre ti its low return on
projects
ranked
,f-r. p..t"n, capital budgeting system
on itrto payback perio<l and average return
of
analysis
careful
"..JJ"g tvtlke Oecidea to seek a

".ri*"r,,
the offer from the Pub']

for
convrioht O bv The University of Hong Kong Centre
This material is used by
ut<ut+s'
cut"
Zu*'
oi#'*"]'"""

Business Cases at The Unloermission of the Centre for Asian

acrc org hk)'
(http:/lwww
Kong
Hong
I"rritf of
t
on investment: Average annuai cashflow

Au"ruq" return
after taxes/Net investment

'I

Perhaps we can

baht for the first

a monthly rental fee of 170'000

pubsare spreadcreate a pub by ourselves' Kariii:ke

,:.

urk yo,-,. new

sinrple. isn't it?

the most difficuli part is to csticosts to

mate future profits and allocate overhead

Kornkrit: I think

pt":.". I'11 work on this first' Then I'11 ask

to their pay"".1,
Woniau to ,ank the projects according
investment'
on
back period and return
of your
Mike: Good. I would like to have the results
analYsis next MondaY

KORNKRIT'S ANALYSES

the offer
began his evaluation by reviewing
revenues
the
from Planetkaraoke Pub and estimating
Beach
project'
;;J;; ;t.ociated with an alternative

f*nf.rit

Karaoke Pub.

Plunet Karaokc Pub

hotel had to set
To make the space ready for lease' the
estimates of
V11ous
uf partitions urrd o '*ait kitchen'
770'000
between
the up-front renovation costs rairged
deprecibe
would
costs
baht and 1,000,000 baht' The
straightJine
the
using
ated over the life ofthe project
the existing
method, with zero salvage value' Since
utilised to
be
would
toiiets, elevators, and carpets

lr
L

i.,
ii

ii
it
;

],r
,li
llll
lii
'i,

.l
,

rr

;i,tl.

:1,

l"r

,, i:i
ii:il i!
rii ir: '

rli

,l

:'

.lltirll
, rii

,iii'r,lr :

866

Part

MunagementAccounting

generated 50 perKornkrit expected revenue to be

that a fair share

sirRDort this proiect, Kornkrit believed
aliocated to the
be
should
optnt"t
"-,-t-"il"t. "t"irr"ud
ofthese facosts
ofthe
rr.i.",. ffr" pro rata aliocation
for the
used
space
the
of
area
:;;ii;,;;^# on the floor
foreseethe
to
Due
baht'
;;t":;. amounted to 55,000

;;;:;;t.
if* pt":".,

and 50 percent frol h.ot11 guests'

4'612'000 baht for the
"";;;;*,ralk-ins
Estinrated total sales wouldbe
at.this flgure
;;;;,;;t "f operation' Kornkrit arrived
per day with an

bv assuming an average of 64 covers

uu"rug" check of 200 baht'

had to turn
Wi*r a seating capaciry of 32' the pub
hours ofthe pub
tables at least twlce u duy' Opttuting
would be frorn 5:00 p'*' to midnight'
was s1x years'
The projected length of the project
5 percent per annum in
Sut.s *"."L*pected to grow at
in covers would be
terms of the ur",ug" chJck' Growth

charge
in activitv, Kornkrit would like to
maintenance
aud
repair
in
for an increase
per annum' The pub would pay all

of 10,000 baht
utility and other expenses'

costs

Beuch Karaoke Ptb

investment rangThe project would require an up-front
rhis reprebaht'
1'200'000
800,00oand
;;;;;.",
capitai
Other
decor'
sented the cost of a moderrr-style
set-up'
klt:|":
tables'
bar
investrrent, including chairs,
baht'
900'000
to
amour-it
would
and karaoke equipment,
Food and beverage costs
Salaries

Other operating exPenses

Depreciation: equipment & furniture
Annual caPital exPendlture

250lo
1

60lo

22o/o

limited due to lirnited caPacitY'

costs were
Kornkrit's estimates for operating

as

lo llorvs:

:1
i:iill

of sales
of sales

of

'.;r'

sales

the prolect using the straight-line

Depreciated equally over the life of
;;[h"4;i,a ]ero'suluag" value at the end
Equalled dePreciation

would
Kornkrit estimated that saiary expenses

ac-

be recruited
fO percent of sales' Staff could
at
maopower
excess
had
hotel
because the
long-tetm confacts
,-frit p"t*. The excess staff had
to meet the deorder
in
kept
*iifr"rfr.-fr"r"1 and were
and mainte;;; of the growing business' Repairs as
for Planet
to be the same

."""t i".
i""*rff,

,rr". ."urvr".e esti;ated

Karaoke Pub.

:,ll:
,,:,ti

learnt
you go. Wanida. This will test what you

at busi-

ness schooll'' he thought'

an email frotn
The following is an excerpt from
Kornkrit:
To: Wanida Daoruang <w'anida@beach-hote1'
phuket>

From: Kornkrit Manming <konikrit@beach-hotet'

phuket>

'subject:

Ranking Capital Projects

Dear Wanida.

CAPITAL STRUCTURE

consisting
t-n.ki g"r"h Hotel has a capital structure The debt
debt'
oi iS p.r."rt equity and 2i percent
;;"r;;; entire\ of lou" from Siam Commercial
i0 Percent' The hotel
Bank bearing an interest rate of
The corporate
cost-of equiry was 12 percent'
tax rate in Phuket was 30 Percent'

;;;;t;'

THE TEST

estimate-s' though it
Kornkrit was quite happy with his
had originally
had taken him more iime than he

needed' The
Now, he had ail the figures he
to the cri*"ri"rr"p was to rank the projects according
He
;";*; by the hotel's capital budgeting system'
new assistant Wanida' a
sarred his file and sent it tohis
"Here
nu""*, gruauate from Thammasat University'

i'fr""gt,

the figures you

. . : I lrar e provided you "r ith all
the two
iu'" p,o.ltttion of future profits for
basis
the
on
projects
the
Please evaluate

.;;;;;t

.,.o,..,r-

average return
profits should be
tuture
that
Note
;;;;,es1ni"*.
rate we
discounted at 5%' This is the interest
CommerSiam
at
.a.r.a to* our time deposits
proposats
old
our
of
some
cial Bank. i beiieve

l-f-,rcit payback period and their

discount rate that

were rejected because we used a
enough cash on.hand
'n'as too high' Since u'e have
think we should .
I
don't
to n ,urr.. it . projects'
when esttmatrng
debt
of
cost
the
iuti" into account
rate'
the discout"lt
Let me know if you have any questions'
Regards-

Kornkrit Mannling

Chapter

27

Longer-Rtrn Decisiorts: Capital Budgetirtg tl67

TABLEAprojectionofNetRoomRevenue(inBaht)(:Roomsales-Roomoperat'n*""0*9
Year

Net room revenue

13,200,000

13,464,000

14,137,000

14,844,000

5,140,000

15,443,000

6. Which investment project should be recommended

Wanida pondered the detaiis of the.projecl.t' SL"

thought theie was something wrong with the hotel's
capiit budgeting system, ;hic]1 ,had not begn.re;
viewed for many years,.'The existing: system

to the board ofdirectors?

When Wanida got home, she had a talk with her husband about the proposed projects. Her husband a social worker" reminded her of the increasing number of
drlrg arrests in karaoke pubs. He suggested that as a
good member of the community, the hotel should not
be involved in this type ofproject'

leFea'

projects according to their av.erage return on investment and payback period. It seemed to her that somethiug was omitted in the analysis' ,
^:
franida was also awarg that certain aspects of the
investment decision were difficuit to quautify' The
om.., nuo expressed his concerns and
dispieasure over the security problems that a karaoke
p"d *igfrt UAng. He was worried that the pub might attract unwelcome guests fromlorltside' This rnight be a
negative factor for the pub in terms ol atttacting
torirists travelling with children' Wanida thought they
accounted for 25 percent of the total patronage lsee
the
Table A for the projection on net room revenue for

Ai;fi;.;,ry

six years].
next
^^''irr.'iorfo*ing

are the questions that Wanida con'

1. What are the relevant cashflows associated with

each project?

2, what criteria,'shoutd be.used

to

evaluate the

projects?

3. How canrl compare'projects,with different lives?

4, What discount rdte: shottld be used?' Wanida'thought
rate of 5 pereent was too low',Investu,rg
l

;d;il";t

in ttre two projects was certainly more risky tban

.
putting the moneY inthe bank'
they
do
how
and
drivers
5. What are the key value
i l'uff""t
projects?
th" attractiveness ofthe
'
.

'

Questions
1. Assess the economic benefits associated with each
of the capital projects. What is the initial outlay?

What are the incremental cashflows over the life of

the project? What is an appropriate discotut rate to
t se-foi discounting the cashflows of the projects?
2. Rank the projects using various measures of investment attractiveness. Do all the measures rank the
projects identically? Why or wby not'? Which crite-

rion is the best?

3. Are the projects comparable

based on the standard

NPV measure, given that they have unequal lives?

What adjustment or alternative method is required
in comparing such Projects?

4. How sensitive

is your ranking to changes in the dis-

count rate'/ What other "key value drivers" would

affect the attractiveness of the projects? Estimate
the sensitivity of your result to a change in any of
the key value drivers.

5. Which project should the hotel undertake?