**BACKGROUND**

BACKGROUND

BACKGROUND

STATEMENT OF THE PROBLEM

Point of View

BACKGROUND

Mike Campbell, the General Manager of Phuket Beach Hotel was considering an offer made by

Planet Karaoke Pub

to lease the unused space owned by the Hotel.

Planet Karaoke pub offered to pay 170,000 baht per month for the first 2 years, and thereafter, and a 5% increment fee for the next 2 years.

Which project should the hotel undertake: Lease or Build?

It will only use 70% of the vacant area since the said hotel plans to use the vacant area for expansion purposes.

Wanida, as the Assistant of Kornkrit

Group 6: Balicano, Lim, Lorilla, Nograles, Salindong

PHUKET BEACH HOTEL

**AREAS OF CONSIDERATION**

Valuing Mutually Exclusive Capital Projects:

AREAS OF CONSIDERATION

Non-discounted Cashflow Techniques:

AREAS OF CONSIDERATION

2) Average Return / Average Rate of Return

- Definition:

It is the rate or return on an investment that is calculated by taking the total cash inflow and by dividing this to the total number of years the investment was held,and then divides that answer by the investment's initial acquisition cost.

- Formula:

Average of cash inflow/ Initial investment

AREAS OF CONSIDERATION

AREAS OF CONSIDERATION

3) Profitability Index

- Definition:

(also called present value index) It is the ratio of total present value of future cash flows to the initial investment. The higher the profitability index, the more desirable the project.

- Formula:

1 + (NPV of All Cashflows / Net Investment)

AREAS OF CONSIDERATION

7) Net Present Value

- Definition:

Present value of cash minus initial investments. It is the excess of the present value of cash inflows generated by the project over the amount of the initial investment.

- Formula:

NPV= PV - required investment

Cash flow Solution

WEIGHTED AVERAGE COST OF CAPITAL

Solutions

Solutions

SENSITIVITY ANALYSIS

Learning Points

Screening Problem

– whether or not to accept a proposed Investment

Learning Points

Ignoring the time value of money would generally result to a

weak analysis

(Simple Payback & Unadjusted ROI)

Consider

uncontrollable external factors

in your decision making (Market Movement, Risk factors, Political, Environmental, Competitors etc.)

Non monetary considerations are often

as important

as monetary considerations

Mike Campbell contacted his financial controller named

Kornkrit Manning

to evaluate the offer made by Planet Karaoke pub.

After Kornkrit have gathered all the data that he needed, the next step was to rank the projects according to the criteria set by the hotel’s capital budgeting system

He have asked his assistant named Wanida to evaluate the 2 projects according to their

payback period

, and to their

average return of investment.

Upon seeing the details of the said projects, Wanida thought there was something wrong with the hotel’s capital budgeting system. The existing system ranked projects according to return on investment and payback period. It seemed to her that something was omitted in the analysis.

Note that the following must be considered:

-The effect of the said project to the image of the hotel

- economic benefits associated with each of the capital projects

-The criteria set by hotel’s capital budgeting system

- Key Value Drivers that would affect the attractiveness of the projects

- There are two ways of computing investment return:

• 1) Consider the time value of money

• 2) Do not consider the time value

In this case:

Phuket Beach Hotel didn’t consider the time value of money, thus, it applied Payback Period in capital budgeting instead of Discounted Payback.

- However, Phuket Beach has to consider the following capital budgeting techniques

1) Payback Period

- Definition:

The technique that measures the length of time required to recover the amount of initial investment

- Formula:

Year of Last Negative Cumulative Cash Flow + (|Last Negative Cumulative Cashflow| / Net Cashflow during Next [Positive] Year)

Discounted Cashflow Techniques:

1) Equivalent Annuity Approach

- Definition:

evaluates the constant annual cash flow produced by a project over its lifetime. It assumes that the projects are annuities. Once the net present value of a project is determined, its equivalent annual annuity can be calculated.

- Formula:

Net Present Value / [1 − (1 + Discount Rate)-life of the project/ discount rate]

2) Internal Rate of Return

- Definition:

(also called discounted rate of return) It is the rate which equates the present value of the future cash inflows with the cost of the investment which produces them. It is the maximum interest rate that could be paid annually over the life of an investment

4) Discount Payback Method

- Definition:

This method recognize the time value of money in payback context. This is used to compute the payback in terms of discounted cash flows received in the future.

- Formula:

Year of Last Negative Cumulative Cash Flow + (|Last Negative Cumulative Cashflow| / Net Cashflow during Next [Positive] Year)

- NOTE:

The cashflow is at a discount rate.

Cash flow Solution

SENSITIVITY ANALYSIS

SENSITIVITY ANALYSIS

Learning Points

NPV method

is a direct measure of the dollar contribution to the stockholders

IRR method

shows the return on the original money invested.

IRR method

will not always give the correct preference between two projects with different lives or with different patterns of earnings but widely used due to practicality.

Profitability Index

is superior to IRR as method of ranking projects although it represents an abstract number which is difficult to explain.

Preference Problem

– Of a number of proposals, each of which has an adequate return, how do they rank in terms of preference?

**RECOMMENDATION**

**BUILD!**

Kornkrit evaluated the offer made by Planet Karaoke Pub and estimated the revenues and costs associated with an alternative project,

Beach Karaoke Pub.

AREAS OF CONSIDERATION

Steps in Equivalent Annuity Approach three-step process to compare projects:

1. Calculate each project’s NPV over its lifetime

2. Compute each project's EAA, such that the present value of the annuities is exactly equal to the project NPV.

3. Compare each project's EAA and select the one with the highest EAA.

AREAS OF CONSIDERATION

Steps in Computing for the IRR:

1. Compute the PV Factor by dividing Net Investment by Annual Cash Returns.

2. Trace the PV Factor in the table for PV of 1 received annually using the life of the project as point of reference.

3. The column that gives the closes amount to the PV facts is the “Discount Rate of Return”.

4. To get the exact rate, interpolation is applied

Solutions

Solutions

Solutions

Solutions

Solutions

Solutions

ALTERNATIVE COURSE OF ACTION 1: NPV

Planet

Beach

ALTERNATIVE COURSE OF ACTION 2: IRR and AROI

Planet

Beach

ALTERNATIVE COURSE OF ACTION 3: Profitability Index

Planet

Beach

ALTERNATIVE COURSE OF ACTION 4: Payback Period and Discounted Period

Planet

Beach