Case study. Phuket Beach Hotel. Valuing Mutually Exclusive Capital Projects.

Questions1. Please asses the economic benefits associated with each of the capital project. What is Initial Outlay?What are the incremental cash flows over the life of the project? What is an appropriate discount rateto use for discounting the cash flows of the project? SN 1 and SN 2 - 40%

2. Are the project comparable based on the standard NPV measure, given that they have unequal lives?What adjustment or alternative method is required in comparing such project? - 10% SN 3

3. How sensitive is your ranking to changes in the discount rate? What other "key value drivers" would affectthe attractiveness of the project like patronage factor; amount of upfront investment; cost of capital, any of the key value drivers?Please estimate the sensitivity of your result to a change in any of the key value drivers. - SN 4 - 30%

4. Which project should the hotel undertake? Why - 10 %

5. Rank the projects using various measures of investment attractiveness. Do all the measure rank the project identically?Why or why not? Which criterion is the best? - SN 5 - 10%

Financial Management. EBS ML. 4th course students.

In case of Hotel, I would like to recommend to lease the Bar. First of all because of Payback period is much shorter ib both scenarios (discounted and non-discounted).secondly Profitability ratio is also much higher, due to the fact that less investments are required to undertake the project. However the main draw

back is EAA which is segnificantly lower as well as ROI. In conclusion, I may say that, in short prospective Lease is option is optimal, however in long term build option may seems to be more profitable in long term (+5 years). The final decision should be undertaken after the Hotel will secure a fixed rate of WACC,

because there are different options are available (see Sensitivity analysis)

1. Please asses the economic benefits associated with each of the capital project. What is Initial Outlay?What are the incremental cash flows over the life of the project? What is an appropriate discount rate

2. Are the project comparable based on the standard NPV measure, given that they have unequal lives?What adjustment or alternative method is required in comparing such project? - 10% SN 3

3. How sensitive is your ranking to changes in the discount rate? What other "key value drivers" would affectthe attractiveness of the project like patronage factor; amount of upfront investment; cost of capital, any of the key value drivers?Please estimate the sensitivity of your result to a change in any of the key value drivers. - SN 4 - 30%

5. Rank the projects using various measures of investment attractiveness. Do all the measure rank the project identically?

In case of Hotel, I would like to recommend to lease the Bar. First of all because of Payback period is much shorter ib both scenarios (discounted and non-discounted).secondly Profitability ratio is also much higher, due to the fact that less investments are required to undertake the project. However the main draw

back is EAA which is segnificantly lower as well as ROI. In conclusion, I may say that, in short prospective Lease is option is optimal, however in long term build option may seems to be more profitable in long term (+5 years). The final decision should be undertaken after the Hotel will secure a fixed rate of WACC,

because there are different options are available (see Sensitivity analysis)

EXHIBIT TN-1THE LEASE OPTION: PLANET KARAOKE PUB - ANALYSIS OF OPERATING CASHFLOW

Project life 4 yearsRenovation cost 770000 bahtCost of capital (WACC) 0.1075Increase in repairs and maintenance 10000Patronage factor 0.5(Figure in bath except where otherwise stated)

Year 0 1 2Net room revenue* 13200000 13464000Reduction in net room revenue 0.125 1650000 1683000

Year 0 1 2Rental income 2040000 2040000Less: Depreciation expenses 192500 192500

Increase in repairs & maintenance 10000 10000Reduction in net room revenue (a) 1650000 1683000

Incremental operating income (b), ( c ) 187500 154500Less taxes (30%) 56250 46350

Net operating profit after taxes (NOPAT) 131250 108150Add: Depreciation 192500 192500Less Capital Expenditure 770000 192500 192500

1 770000Free Cash Flow -770000 323750 300650PVIF (WACC %) 1 0.9029 0.8153Discounted free cash flow -770000 292325 245117Notes:1. Average return on investment (ROI) is calculated as the average of the NOPAT over the life of the project divided by average the upfront investment.

2. The Equivalent Annual Annuity is that level annual payment over the life of the investment that yields a present value just equal to the net present value of the entire cash flow stream.

* Net room revenue = Room revenue - Room operating expenses

These cash flows, called incremental cash flows, represent the changes in the firm's total cash flow that occurs as a direct result of accepting the project.

In this case, the overhead and salary expenses of the excess labor can be considered as sunk cost.

See SN 4 Sensitivity analyses: Cost of Capital PVIFA Rate NPVPVIFA =[(1+k)n - 1]/k 8% 3.31210 0.0800 275944.11

PVIFA =[(1+k)n - 1]/k WACC% 3.11908 0.1075 214849.48PVIFA =[(1+k)n - 1]/k 12 % 3.03730 0.1200 188992.20PVIFA =[(1+k)n - 1]/k 14% 2.91370 0.1400 149885.44PVIFA =[(1+k)n - 1]/k 16% 2.79820 0.1600 113352.73PVIFA =[(1+k)n - 1]/k 18% 2.69010 0.1800 79173.36

The annuity is determined by solving for "A": A= NPV/PVIFA n,k, where PVIFA =[(1+k)n - 1]/k n=number of periods k=discount rate.

(a) Consider externalities. Externalities represent the effect of a project on other parts of the firm. In this case, the possible reduction in room sales should be considered in the analysis for both project.

(b) Identify the incremental cash flow. In evaluating the project in this case, we should focus on those cash flows that occur if and only if we accept project.

( c ) Ignore sunk cost: a sunk cost is an outlay that has already been committed or that has already occurred, hence is not affected by the decision under consideration.

PVIFA =[(1+k)n - 1]/k 20% 2.58870 0.2000 47149.40PVIFA =[(1+k)n - 1]/k 22% 2.49361 0.2200 17103.01

Decrease in net room revenue 25%0 0%

0.25 6.25%0.5 12.50%

0.75 18.75%1 25.00%

3 414137000 14844000

1767125 1855500

3 42142000 2249100

192500 19250010000 10000

1767125 1855500172375 191100

51713 57330 Payback Period 2.46Discounted payback 3.01

120662.5 133770 Average return on investment (ROI) 0.64192500 192500 IRR 23%192500 192500 MIRR 18%

Profitability index 1.28313163 326270 NPV 2148490.7362 0.6647 EAA 68882.36

230536 216871 PVIFA =[(1+k)n - 1]/k 3.11908Notes:1. Average return on investment (ROI) is calculated as the average of the NOPAT over the life of the project divided by average the upfront investment.

2. The Equivalent Annual Annuity is that level annual payment over the life of the investment that yields a present value just equal to the net present value of the entire cash flow stream.

These cash flows, called incremental cash flows, represent the changes in the firm's total cash flow that occurs as a direct result of accepting the project.

EAA83313.9468882.3862223.7551441.6240509.1629431.38

Patronage factor

The annuity is determined by solving for "A": A= NPV/PVIFA n,k, where PVIFA =[(1+k)n - 1]/k n=number of periods k=discount rate.

Externalities represent the effect of a project on other parts of the firm. In this case, the possible reduction in room sales should be considered in the analysis for both project.

. In evaluating the project in this case, we should focus on those cash flows that occur if and only if we accept project.

a sunk cost is an outlay that has already been committed or that has already occurred, hence is not affected by the decision under consideration.

18213.546858.74

EXHIBIT TN-2THE LEASE OPTION: PLANET KARAOKE PUB - ANALYSIS OF OPERATING CASHFLOW

Project life 6 yearsUpfront investment

renovation 800000 bahtequipment 900000 baht

Tax rate 30%Cost of capital (WACC %) 0.1075Sales growth rate 5% of salesFood and beverage cost 25 % of salesSalary 16% of salesOther operating expense 22% of salesIncrease in repairs and maintenance 10000 bahtAnnual capital expenditure equal depreciationPatronage factor 0.5(Figure in bath except where otherwise stated)

Year 0 1Net room revenue* 13200000Reduction in net room revenue 0.125 1650000

Year 0 1Sales 4672000Less: Food and beverage cost 1168000

Other operating expenses 1027840Depreciation expenses 283333Increase in repairs & maintenance 10000Reduction in net room revenue 1650000

Incremental operating income 532827

Less taxes (30%) 159848

Net operating profit after taxes (NOPAT) 372979Add: Depreciation 283333

1 1700000 656312Less Capital Expenditure 283333

Upfront investment 1700000Free Cash Flow -1700000 372979PVIF (WACC%) 1 0.9029Discounted free cash flow -1700000 336775

Payback period 3.84Discounted payback 4.95Average return on investment (ROI) 77%IRR 17%MIRR 14%Profitability index 0.23NPV 373043.3EAA 87544.6PVIFA =[(1+k)n - 1]/k 4.26118

See SN 4 Sensitivity analyses: Cost of Capital PVIFA RatePVIFA =[(1+k)n - 1]/k 8% 4.62290 0.0800

PVIFA =[(1+k)n - 1]/k WACC % 4.26118 0.1075PVIFA =[(1+k)n - 1]/k 12 % 4.11140 0.1200PVIFA =[(1+k)n - 1]/k 14% 3.88870 0.1400PVIFA =[(1+k)n - 1]/k 16% 3.68470 0.1600PVIFA =[(1+k)n - 1]/k 18% 3.49760 0.1800PVIFA =[(1+k)n - 1]/k 20% 3.32550 0.2000PVIFA =[(1+k)n - 1]/k 22% 3.16692 0.2200

0 0%0.25 6.25%

0.5 12.50%0.75 18.75%

1 25.00%

2 3 4 5 613464000 14137000 14844000 15140000 15443000

1683000 1767125 1855500 1892500 1930375

2 3 44905600 5150880 5408424 5678845.2 5962787.461226400 1287720 1352106 1419711.3 1490696.8651079232 1133193.6 1189853.28 1249345.944 1311813.2412

283333 283333 283333 283333 28333310000 10000 10000 10000 10000

1683000 1767125 1855500 1892500 1930375623635 669508 717631 823955 936569

187090.4 200852 215289 247186 280971

436544 468656 502342 576768 655598283333 283333 283333 283333 283333719878 751989 785675 860102 938932283333 283333 283333 283333 283333

436544 468656 502342 576768 6555980.8153 0.7362 0.6647 0.6002 0.5419355911 345003 333906 346165 355284

Patronage factor

Decrease in net room revenue 25%

NPV EAA566564.19 122556.01373043.31 87544.58293274.62 71332.06175074.01 45021.2267335.79 18274.43-31091.39 -8889.35

-121211.21 -36449.02-203901.09 -64384.74

Summary of result

Lease OptionPlanet Karaoke Pub

Payback period 2.465Discounted payback 3.009Average return on investment (ROI) 0.641IRR 0.232MIRR 0.178Profitability index 1.279

EAA 68882.36

Build OptionBeach Karaoke Pub

Payback period 3.84Discounted payback 4.95Average return on investment (ROI) 0.77IRR 0.17MIRR 0.14Profitability index 0.23

EAA 87544.58

The Build Option

Patronage Cost of CapitalFactor 0.08 0.1075 0.12 0.14 0.16

0 1370536 1332436 1314853 1286391 12575450.25 746546 709990 693092 663706 637910

0.5 122557 87545 71332 45022 182740.75 -501433 -534901 -550428 -575663 -601361

1 -1125422 -1157347 -1172189 -1196348 -1220996

The Lease Option

Patronage Cost of CapitalFactor 0.08 0.1075 0.12 0.14 0.16

0 1279229 1263950 1256911 1245531 12340110.25 672952 658428 651724 640869 629862

0.5 66676 52906 46536 36207 257120.75 -539601 -552616 -558651 -568455 -578437

1 -1145877 -1158138 -1163838 -1173117 -1182587

Difference in EA (Build - Lease)

Patronage Cost of CapitalFactor 0.08 0.1075 0.12 0.14 0.16

0 91307 64486 57942 40860 235340.25 73594 51562 41368 24837 8048

0.5 55881 34639 24796 8815 -74380.75 38168 17715 8223 -7208 -22924

1 20455 791 -8351 -23231 -38409

Decision

Patronage Cost of CapitalFactor 0.08 0.1075 0.12 0.14 0.16

0 Build Build Build Build Build0.25 Build Build Build Build Build

0.5 Build Build Build Build Lease0.75 Rej. Both Rej. Both Rej. Both Rej. Both Rej. Both

1 Rej. both Rej. Both Rej. Both Rej. Both Rej. Both0 Build Build Build Build Build

0.25 Build Build Build Build Build0.5 Build Build Build Build Lease

0.75 Rej. Both Rej. Both Rej. Both Rej. Both Rej. Both1 Rej. both Rej. Both Rej. Both Rej. Both Rej. Both

Sensitivity Analysis - Two Factors

Factors: Cost of Capital and Patronage Factor

Equivalent Annuity (EA) in baht

The Build Option

Patronage Cost of Capital

Factor 0.08 0.1075 0.12 0.14 0.16

0 1370536 1332436 1314853 1286391 1257545

0.25 746546 709990 693092 663706 637910

0.5 122557 87545 71332 45022 18274

0.75 -501433 -534901 -550428 -575663 -601361

1 -1125422 -1157347 -1172189 -1196348 -1220996

The Lease Option

Patronage Cost of CapitalFactor 0.08 0.1075 0.12 0.14 0.16

0 1279229 1263950 1256911 1245531 12340110.25 672952 658428 651724 640869 629862

0.5 66676 52906 46536 36207 257120.75 -539601 -552616 -558651 -568455 -578437

1 -1145877 -1158138 -1163838 -1173117 -1182587

Difference in EA (Build - Lease)

Patronage Cost of CapitalFactor 0.08 0.1075 0.12 0.14 0.16

0 91307 64486 57942 40860 235340.25 73594 51562 41368 24837 8048

0.5 55881 34639 24796 8815 -74380.75 38168 17715 8223 -7208 -22924

1 20455 791 -8351 -23231 -38409

Decision

Patronage Cost of CapitalFactor 0.08 0.1075 0.12 0.14 0.16

0 Build Build Build Build Build0.25 Build Build Build Build Build

0.5 Build Build Build Build Lease0.75 Rej. Both Rej. Both Rej. Both Rej. Both Rej. Both

1 Rej. both Rej. Both Rej. Both Rej. Both Rej. Both

0.181228335

609723-8889

-627501-1246114

0.181222356

61870615057

-588592-1192241

0.185979

-8983-23946-38909-53873

0.18BuildLeaseLeaseRej. BothRej. bothBuildLeaseLeaseRej. BothRej. both

0.18

1228335

609723

-8889

-627501

-1246114

0.181222356

61870615057

-588592-1192241

0.185979

-8983-23946-38909-53873

0.18BuildLeaseLeaseRej. BothRej. both

I. Non-discount Cash flow Techniques

a) Payback PeriodAdvantages Disadvantages2.4649343392009 3.84Lease option Build option

Lease option is better because the Hotel will get their investment back quicker! Difference is 14 month

b) Average return on investment Advantages Disadvantages

0.77 0.64Build option Lease option

Build option is more profitable in case of return of investments (Hotel may consider it major factor in long term investment plan)II. Discount Cash flow Technique

c ) Internal rate of return (IRR)Advantages Disadvantages

0.23 0.17Lease option Build option

Lease option is preferable in case of on running business activities, 0,05 is significant difference in such project, and that can be a major factor to choose a Lease optiond ) Modified internal rate of return (MIRR)

Advantages Disadvantages

0.18 0.14Lease option Build option

Lease is option is more profitable even after all discounted options are taken, therefore it may give a strong argument in short term invsetment plan, rather than in long-term.e ) Profitability Index

Advantages DisadvantagesLease option Build option

1.28 0.23

Lease option is much profitable

f ) Net present Value Advantages DisadvantagesLease option Build option

214849 373043.31

According NPV the lease option is still better, due to the fact that, difference between Invested Capital is around 1000000, and investers would like to see greater NPV from Build option

g) Equivalent Annual AnnuityAdvantages DisadvantagesLease option Build option3.1190785712419 4.2611813

Build option is more profitable in case of return of investments (Hotel may consider it major factor in long term investment plan)

Lease option is preferable in case of on running business activities, 0,05 is significant difference in such project, and that can be a major factor to choose a Lease option

Lease is option is more profitable even after all discounted options are taken, therefore it may give a strong argument in short term invsetment plan, rather than in long-term.

According NPV the lease option is still better, due to the fact that, difference between Invested Capital is around 1000000, and investers would like to see greater NPV from Build option

Using NPV Function Using NPV FunctionRate 10.8% RateN Cash Flows N

0 ($770,000) 01 $323,750 12 $300,650 23 $313,163 34 $326,270 4

NPV $214,849.48 56

NPVNumerical Solution for NPV Project A

Rate 5.0%N Cash Flows PVIF(I%,N) DCF

0 ($770,000) 1 -$770,000.00 Numerical Solution for NPV Project A1 $323,750 0.9029 $292,325.06 Rate2 $300,650 0.8153 $245,117.17 N3 $313,163 0.7362 $230,535.89 04 $326,270 0.6647 $216,871.36 1

NPV $214,849.48 23456

Using NPV Function10.8%

Cash Flows-1700000

372979436544468656502342576768655598

$373,043.31

Numerical Solution for NPV Project A5.0%

Cash Flows PVIF(I%,N) DCF-1700000 1 -$1,700,000.00

372979 0.9029 $336,775.32436544 0.8153 $355,910.52468656 0.7362 $345,002.82502342 0.6647 $333,906.23576768 0.6002 $346,164.61655598 0.5419 $355,283.81

NPV $373,043.31

Project X Rate 12% Time 0 1 2 3 4Cash Flow -770000 131250 108150 120662.5 133770Discounted NCF -770000 292325.0564 245117.1726 230535.8902 216871.3602Cumulative NCF -477674.944 -232557.771 -2021.88076 214849.4795Discounted Payback Period N/A N/A N/A N/A 3.00932295

Project Y Rate 12% Time 0 1 2 3 4Cash Flow -1700000 372978.6667 436544.2667 468655.6467 502341.9707Discounted NCF -1700000 336775.3198 355910.515 345002.8235 333906.2325Cumulative NCF -1363224.68 -1007314.17 -662311.342 -328405.109Discounted Payback Period N/A N/A N/A N/A N/A

5 6576768.24 655598.31346164.61 355283.8317759.496 373043.324.9486964 N/A

WACC 1% 1% 1% 1% 1%Time 0 1 2 3 4Cash Flows -770000 323750 300650 313162.5 326270IRR 23.20%

Project BWACC 1% 1% 1% 1% 1% 1%Time 0 1 2 3 4 5Cash Flows -1700000 372978.6667 436544.2667 468655.6467 502341.97067 576768.2IRR 17.35%

Project B1%

6655598.3

Project A Project BCost of Capital 10.75% Cost of Cap 10.75%N Cash Flows N Cash Flows

0 -$770,000 0 -$1,700,0001 $323,750 1 $372,9792 $300,650 2 $436,5443 $313,163 3 $468,6564 $326,270 4 $502,342

MIRR 17.78% 5 $576,7686 $655,598

MIRR 14.47%

WACC 11% 0.9029 0.8153 0.7362 0.6647Time 0 1 2 3 4Cash Flows -$770,000 $323,750 $300,650 $313,163 $326,270PI 1.28

Project BWACC 1 0.9029 0.8153 0.7362 0.6647 0.6002 0.5419Time 0 1 2 3 4 3 4Cash Flows -$1,700,000 $372,979 $436,544 $468,656 $502,342 $576,768 $655,598PI 0.23

N 0 1 2 3 4Cash Flow ($770,000) $323,750 $300,650 $313,163 $326,270 Regular Payback Period N/A N/A N/A 2.46 N/A

N 0 1 2 3 4Cash Flow ($1,700,000) $372,979 $436,544 $468,656 $502,342 Regular Payback Period N/A N/A N/A N/A 3.84

3 4$576,768 $655,598

N/A 2.00

Project A0 1 2 3 4 Sum ROI

-770000 323750 300650 313162.5 326270 1263832.5 0.641341

Project B0 1 2 3 4 5 6 Sum

-1700000 372978.7 436544.3 468655.6 502342 576768.2358667 655598.3 3012887.10086

Project BROI0.772287

Annuity FactorInterest Rate 10.75% Interest Rate 10.75%Periods 4 Periods 6Annuity Factor 3.119078571 Annuity Factor 4.2611813125096

See SN 4 Sensitivity analyses: Cost of PVIFA NPV EAAPVIFA =[(1+k)n - 1]/k 8% 3.31210 8.00 -81092.97

PVIFA =[(1+k)n - 1]/k WACC% 3.11908 10.75 29937.55PVIFA =[(1+k)n - 1]/k 12 % 3.03730 12.00 -57166.40PVIFA =[(1+k)n - 1]/k 14% 2.91370 14.00 -49798.75PVIFA =[(1+k)n - 1]/k 16% 2.79820 16.00 -44108.70PVIFA =[(1+k)n - 1]/k 18% 2.69010 18.00 -39583.13PVIFA =[(1+k)n - 1]/k 20% 2.58870 20.00 -35898.39PVIFA =[(1+k)n - 1]/k 22% 2.49361 22.00 -32840.38