Phuket Beach Hotel: Valuing Mutually Exclusive Capital Projects Harvard Case Solution & Analysis

Introduction:

The current scenario of the company is based on the selection of two options that are based on utilizing the unused space of the Phuket Beach hotel. A pub named as Planet Karaoke Pub made an offer to the hotel through signing a four year leasing contract with Phuket beach Hotel on a rent of 170,000 Baht on a monthly basis. By making the evaluation of this option, the manager of the company is considering another option that is making its own pub on unutilized space. The life of the project will be of 6 years and thus the projects are known to be mutually exclusive. Capital expenditure will be involved in both the projects and that in turn will result in dissimilar operating cash flows. For this, the manager needs to evaluate the costs along with the benefits that the hotel will get and that in turn will help the company to identify economic and financial viability of the project. In order to find the cost and benefits, the company needs to identify the returns through IRR and NPV. The manager of the company Mike Campbell need to analyze and evaluate both projects and decide which alternative will work best for the hotel.

Available alternatives:

Alternative # 1:

Lease option, that is based on giving the space to Planet Karaoke Pub and earn a rent from it.

Alternative # 2:

The second alternative is the build option that is building beach owns pub.

It doesn’t matter that what will be the management’s decision. The management of the company only needs a project that will give the maximum revenue through minimum expenses. The management of the company realized that it’s better and wise option to utilize its unused space and money as well as despite saving money just in banks.

  1. Please assess the economic benefits and costs associated with each of the capital projects. What are relevant incremental cash flows for the build and lease options? (For the calculation of incremental cash flows, create two spreadsheets – one for build option and the other for the lease option).

Answer # 1:

In order to identify which project is best, the finance team of the hotel needs to identify the economic benefits and costs associated with these two lease options. Relevant economic benefits have been identified to identify and analyze the feasibility of both the projects. In order to do this, the first thing to identify is the incremental cash flows along with initial outlays of both the projects. This can be done through analyzing and identifying the proper discount rates and this discount rate can be identified with the help of weighted average cost of capital. The data has been given in the case that the weights of debt and equity is 25% and 75% respectively along with the cost of equity as 12%. In addition to this, the interest rate on debt has given as 10% and the tax rate is 30%. From this data, WACC is found to be 10.75% and this discount rate is much higher than the estimated growth rate of the project that was 5%. Moreover, the initial costs of both the projects have shown that it is better for the company to opt for alternative number one. By choosing the Planet Karaoke project, the initial requirement for the company would be approximately 1,000,000 Baht and this amount is much lesser than that for Beach Karaoke that is nearly 1,700,000 to 2,100,000 million baht. It was because of the additional costs related to the equipment that is based on managing and running a night club. The incremental cash flows of the company has been calculated through a discount rate of 10.75% and is calculated in the spreadsheet attached. These cash flows are as follows:

Incremental Cash flows
YearsPlanet Karaoke PubHotel Beach Pub
Year 1516,250887,312
Year 2497,770955,498
Year 3522,060999,386
Year 4547,5401,045,445
Year 51,125,052
Year 61,209,184

2.      What is the appropriate discount rate for discounting the incremental cash flows?

Answer # 2:

The discount rate suggested by the new assistant Wanida was definitely not 5% as she thought that this discount rate is too low as it is more risky for the company in making investment rather than putting their valuable cash in banks......................

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Phuket Beach Hotel has the opportunity to rent it is not enough space in a karaoke bar and earn rental income. Also, the hotel can develop unused space and create your own pub. The general manager of the hotel to decide which of the two major projects to recommend to the hotel owners. This case is enough information to build a cash flow for each project and evaluate mutually exclusive projects using a variety of criteria. "Hide

Su Han Chan, Ko Wang, Maria Ho Source: University of Hong Kong, 4 pages. Publication Date: August 15, 2001. Prod. #: HKU145-PDF-ENG

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