Phuket Case - Introduction and Cash Flow Explanation
Introduction
Phuket Beach Hotel (PBH) has an underutilized space located on the second floor of the main building. Management has decided to consider investing in one of the two mutually exclusive projects which can effectively utilize the spare space of the Hotel. The first one is an offer made to them by Planet Karaoke pub to sign a four-year lease agreement and earn a monthly rental fee of 170,000 baht for the first two year and at a 5% increment for the next two years. The second opportunity would be to create their own pub to be called Beach Karaoke. To evaluate the two mutually exclusive projects, we have to consider the following criteria:
• The present capital budgeting system ranks projects according to their payback period and average return on investment. Ranking projects is often used in the situation of capital rationing. PBH might have had difficulties in terms of availability of cash, which would justify the use of the Payback method. However, it’s an old system that hasn’t been revised for years, now conditions have changed. Liquidity of the projects is not essential, since the hotel has enough cash on hand to finance the projects without the need to take on additional debt.
• The PBH Financial Controller Kornkrit felt that past proposals were rejected because the discount rate used was too high. In order to make the valuation as accurate as possible, we have to find a proper discount rate which can reflect the reality.
• There are also some qualitative factors which are difficult to quantify. For example, a karaoke pub might raise security concerns which could decrease the attractiveness of the hotel, especially to the tourists with children. Those tourists accounted for approximately 25% of the total patronage. But it is hard to identify the potential loss in this group of customers.
The issues and concerns with opening up a karaoke pub in the hotel should be looked into further. There also needs to be a proper evaluation of the cash flows
Phuket Beach Hotel (PBH) has an underutilized space located on the second floor of the main building. Management has decided to consider investing in one of the two mutually exclusive projects which can effectively utilize the spare space of the Hotel. The first one is an offer made to them by Planet Karaoke pub to sign a four-year lease agreement and earn a monthly rental fee of 170,000 baht for the first two year and at a 5% increment for the next two years. The second opportunity would be to create their own pub to be called Beach Karaoke. To evaluate the two mutually exclusive projects, we have to consider the following criteria:
• The present capital budgeting system ranks projects according to their payback period and average return on investment. Ranking projects is often used in the situation of capital rationing. PBH might have had difficulties in terms of availability of cash, which would justify the use of the Payback method. However, it’s an old system that hasn’t been revised for years, now conditions have changed. Liquidity of the projects is not essential, since the hotel has enough cash on hand to finance the projects without the need to take on additional debt.
• The PBH Financial Controller Kornkrit felt that past proposals were rejected because the discount rate used was too high. In order to make the valuation as accurate as possible, we have to find a proper discount rate which can reflect the reality.
• There are also some qualitative factors which are difficult to quantify. For example, a karaoke pub might raise security concerns which could decrease the attractiveness of the hotel, especially to the tourists with children. Those tourists accounted for approximately 25% of the total patronage. But it is hard to identify the potential loss in this group of customers.
The issues and concerns with opening up a karaoke pub in the hotel should be looked into further. There also needs to be a proper evaluation of the cash flows