capital budgeting case

Project Description:

it is sunday afternoon and the general manager of holiday inn, marie, is dreading the start of the work week. lately, she has been feeling even more frustrated with the board of directors. the board has, time and again, rejected past development proposals and marie is afraid that it will be doing the same thing for the new proposal that has been offered by westcoast spa.

westcoast spa, a california company, has been expanding in the northeast. it has opened a spa in
stowe, vermont, and another in the berkshires, massachusetts, and is now planning to open a

third one in the east end’s south fork of long island, new york.
westcoast is eyeing an unused

space owned by holiday inn. the space is located on the third floor of the main


about 1/5 of the 10,000 sq. ft. space will be used to build a wide pathway with a

garden trellis along the path to connect the main building to a new addition under construction. the rest of the space can be rented out to a third party.

marie has gone through similar development proposals that have been rejected by the board.
one of the proposals was to convert the unused space to a karaoke bar, and another to a wine bar. the proposals were rejected based on the payback period and average accounting rate of return. another basis for the rejection was the chief security officer’s concern that a bar would attract security problems, as well as unwanted guests. given that the ranking of projects is based on these two aforementioned criteria plus some unquantifiable factors, marie has to be even more careful in the analysis that has to be conducted in considering the offer by westcoast.

westcoast spa has offered to lease the unused property with holiday inn for 4 years for a monthly rent of $25,000 for the first 2 years, and a 7% annual increase for the next two years.

the next morning, marie sets up a meeting with jim naruda, the inn’s financial controller, to discuss westcoast’s offer.

the projects

marie’s discussion with jim is as follows:


it is really important that we evaluate carefully the offer we received from westcoast. i

will need all the feedback you can give me as soon as possible.

jim: i will put aside some of my work and do a detailed analysis for you. it will take at least 4 days to do this. however, i just think that we cannot present this analysis as a stand-alone


we need to give some alternatives.


marie: i agree with you 100%. the east end is no longer just a summer resort area. we have become a destination place even in the winter months. maybe we can create a spa ourselves.

jim: yes, i heard that the north fork spa and inn has been turning away customers from all over the metropolitan area who want to book with them. our very own spa could certainly be the alternative to westcoast’s offer.

marie: why don’t you do a careful analysis of the projects. ask your new assistant, isabel
ayarza, to help you. i hope the analysis will not be that complicated.

jim: i expect that the most difficult part is to estimate the revenues and to allocate overhead costs to each project. i will work on these estimates and then ask isabel to rank the projects according to their payback period and average accounting rate of return.

marie: that’s great. i will be expecting the evaluation report on friday. if you need any other info, just call me.

jim naruda’s analysis

jim starts his evaluation of the two projects – the offer from westcoast spa and the alternative project, hoiday inn spa.

westcoast spa. the hotel has to make the space ready for lease. it has to set up the partitions and put in all the necessary plumbing and new flooring. the estimates for the up-front renovation costs range from $225,000 to $265,000 to be depreciated over the life of the project using straight-line with a zero salvage value. any other spa-related installations will be assumed by westcoast. the existing elevators and toilets would be used by westcoast and, therefore, jim believes that a pro-rata allocation of the costs of the facilities should be based on the area that
will be used. he estimates this to be $12,000 per annum. in addition, jim will also allocate to westcoast $2,500 per annum for any repair and maintenance costs that will be incurred. westcoast will pay all utilities and other operating expenses.

holiday inn spa. if the hotel creates its own spa, the up-front investment is estimated to range between $200,000 to $250,000. other capital investments will include the installations of whirlpools, sauna, and massage and facial rooms. these additional investments will amount to $100,000.

jim expects revenues to be generated 40% from hotel guests and the other 60% from outside bookings. total sales are estimated to be $875,000 the first year of operation. jim
comes up with these estimates based on their expected hotel bookings per year and his prediction of demand for spa services from long island and the surrounding area. jim also included the spill-over effect from outside spa guests patronizing its own restaurant, adding additional covers per day. he estimates this to generate additional revenues of $75,000 per annum.


the project is estimated to last for 6 years. sales are expected to grow at 5% per year. jim’s estimates of the operating costs are as follows:

salaries 25% of sales
other operating expenses 40% of sales
depreciation- equipment & furniture straight-line; zero salve value
capital expenditure equal annual depreciation

cost of capital. holiday inn has a capital structure consisting of 30% debt and 70% equity. the debt consists of loans from the long island bank with an interest rate of 7.2%. the cost of equity of the hotel shareholders is 15%. the corporate tax rate is 35%.

isabel ayarza’s test. jim is quite satisfied with the estimates of revenues and costs he has done. the next step is to rank the mutually-exclusive projects according to the criteria used by the hotel. he saves all his worksheets and analysis and sends them to his new assistant, isabel, a recent graduate of suny binghamton, to do the ranking task. his unspoken words are “here you are, isabel. let’s see what you learned in business school!”

below is jim naruda’s email to isabel:

dear isabel,
i have provided you with all the estimates of revenues and costs that you will need to project future profits for the two projects under consideration. please evaluate and rank the projects according to the payback period and cash flow analysis. the future profits should be discounted at 4% which is the average interest rate we earn from our cds with long island bank. i think previous development proposals were rejected by the board because the discount rate we used was too high. we do have enough cash on hand to finance the projects. i don’t think the appropriate discount rate should be based on our cost of debt.

i promised marie that we will be able to deliver our analysis by friday. please let me know if there will be a problem meeting that deadline. if you have any questions, please do not hesitate to contact me.

jim naruda


isabel finds this task a challenging and exciting one. now she can show what she learned in business school. she examines all the details of the projects. she thinks there is something


wrong with the hotel’s criteria for choosing capital projects. as far as she can tell, the capital budgeting system has not been reviewed nor questioned by anyone for many years.

isabel is also aware that, when making investment decisions, there are many factors that are difficult to quantify. she thinks that the hotel will project a different image to the public if it offers spa services. instead of a hotel that caters to families, it will be perceived more as a hotel that caters to couples and singles. this might have a negative impact in terms of attracting tourists traveling with children. isabel thinks that the total patronage for the hotel might decline by 12%. below is the projection on net room revenue for the next six years.

projection of net room revenue
(room sales – room operating expenses)

year 1 2 3 4 5 6
net room
revenue $2,500,000 $2,575,000 $2,652,000 $2,732,000 $2,813,000 $2,900,000

isabel wrote down the following questions which she believes she has to address thoroughly:
1. what are the relevant cash flows associated with each project?
2. what criteria should be used to evaluate the projects? how do i convince the board that it is time to change the capital budgeting system?
3. how can i account for the different lives of the two projects?
4. should i use 6% as the discount rate? even if the hotel has enough cash on hand, it is obvious that investing in either project under consideration is more risky than investing in cds.
5. what are the most important aspects of the projects that will affect the attractiveness of the projects?
6. which investment project should i recommend to the board of directors?

isabel plans to submit to jim naruda her recommendation in 3 days in a memo complete with all the analysis she plans to do, the supporting documents, the ranking and her final recommendation. she knows it is not only the quantitative part of her analysis that will matter, but also the narrative she will write to support her recommendation. she is convinced that the board needs to be educated regarding the capital budgeting process. isabel believes she is up to the task.
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