Schedule 2: Tiff’s Restaurant June actual volume of covers served, average revenue
12.10 The Stellar Views’ Chapel Case Study
Introduction • • •
This is a case that draws on a real investment opportunity that was under consideration in a large Australian hotel. The numbers stated in the case have been modified and also the name of the hotel changed in order to provide anonymity to the hotel concerned. The case is presented partly as an illustration of the difficult nature of estimating future cash flows when a hotel is considering an investment in a new activity that is significantly different from its existing activities. Textbooks that provide an overview of capital budgeting too frequently give extensive consideration to the different appraisal techniques that can be used, but give little attention to the problem of generating a proposed investment’s cash flow estimates.
Case description • • •
The Stellar Views Hotel is located in a popular tourist region of Australia. The hotel comprises two adjoining buildings located near a beach. The main building is 25 storeys high, and the second is 6 storeys high. The smaller of the two buildings has a large flat roof with easy pedestrian access available from the large building. A small tennis facility comprising two courts has occupied this roof for the last ten years and the courts are now in need of a major overhaul. The tennis facility has been provided as a free service to hotel guests.
Stellar Views’ management is considering dismantling the tennis facility and replacing it with a small 100-seat wedding chapel. The management believes there is considerable potential demand for this service, especially in light of the photo opportunities that the chapel’s position would offer. In addition to catering to the local market, the chapel would be targeted towards the many Japanese visitors that come to the region to get married. Part of the rationale for the strong anticipated demand relates to a change in the type of wedding/reception/accommodation mix currently sought in the market for weddings. In earlier years it was typical for different venues to be used for the wedding service, wedding reception and also the accommodation booked before and after the wedding. Following consultation with a Japanese tourist operator, Stellar Views’ management has determined that couples are increasingly seeking a facility that can enable the wedding service, reception and accommodation to be provided at a single site. Convenience and cost issues are the main factors that lie behind this change. A single venue signifies that couples can benefit from packaged prices and also save on additional costs such as limousine hire and church decorators.
The hotel’s management has commissioned a consulting group to develop estimates of the initial costs of building the chapel and also the demand for wedding ceremonies. It has been estimated that the chapel will cost $1,000,000 to build. The schedule overleaf presents the consulting company’s demand estimates. The demand estimates are based on a ceremony fee of $550. This ceremony price also covers the provision of floral arrangements, pew bows, topiary trees and a red carpeted aisle.
The hotel has also projected that each ceremony will have a variable cost of $100 and that annual fixed costs associated with maintaining the chapel and surrounding gardens will be $10,000. Further, it has been estimated that 90% of the Japanese inbound market ceremonies will result in a reception held at the hotel and extra guests staying at the hotel. It has been estimated that each Japanese reception held at the hotel will generate a contribution of $2,000. For the 90% of Japanese
Jan. & Feb. March & April May & June July & August Sept. & Oct. Nov. & Dec. Total
Local market
Friday 0 0 2 0 4 1 7
Saturday 6 16 14 7 40 10 93
Sunday 0 2 4 0 8 1 15
Sub-total 6 18 20 7 52 12 115
Japanese inbound market
Monday 0 1 2 0 2 0 5
Tuesday 0 3 10 0 8 3 24
Wednesday 0 3 10 0 8 3 24
Thursday 0 3 9 0 8 3 23
Friday 0 1 1 0 2 0 4
Sub-total 0 11 32 0 28 9 80
Total ceremonies held 6 29 52 7 80 21 195
a The projected demand for ceremonies is based on a proposed ceremony fee of $550.
Hospitality, Leisure & Tourism Series ceremonies that will result in extra guests staying at the hotel, it has been estimated that each ceremony will result in an additional $1,000 of accommodation profit earned by the hotel.
With respect to the wedding ceremonies booked by locals, it is estimated that 20%
will result in a reception at the hotel and these receptions will contribute $5,000 per reception. Further, it is estimated that the average local market ceremony will result in 15 extra room sales which will generate an additional contribution of $100 per room. The hotel’s financial controller has determined that the viability of this chapel investment will be assessed using a 14% discount rate.
Required • • •
(a) Prepare an NPV analysis of the proposed chapel investment for Stellar Views’
management. Assume that the hotel’s management feels that the projected demand schedule presented above will apply for the first five years following the chapel’s construction. In addition, it feels the contributions earned from receptions and accommodation associated with ceremonies will be constant in the chapel’s first five years. When calculating NPV, the management has a policy of not looking at cash flow estimates beyond a five-year period.
(b) Describe whether you see the proposed chapel investment as risky. With respect to the discount rate that should be used when calculating the chapel’s NPV, do you feel Stellar Views should use its cost of capital?
(c) What sources of information do you feel the hotel might use with respect to developing its initial estimate of the cost of building the chapel?
Solutions to problems