We will write a custom Coursework on Financial Evaluation of Alternatives for City Hotel Limited specifically for you
301 certified writers online
The management of the City Hotel Limited seeks to evaluate various alternative options that are recommended with an aim of improving performance. The company has faced a drop in performance since its inception. This can be attributed to the competition and deterioration of the condition of the rooms.
The options proposed by the management seek to increase the occupancy of the room and conditions of the room. Three options have been proposed by the management. The paper seeks to analyze the viability of these options. Various financial analysis tools and techniques for evaluating projects will be used (Powell & Baker 2005).
Outline of options
There are three options that are proposed by the management. These options are discussed below.
The first option seeks to reduce the price of hotel rooms, especially during weekends with an aim of increasing hotel occupancy. This option was arrived at after evaluating the impact of price reductions on occupancy levels. There will be no capital costs required for this option.
The second option seeks to carry out major refurbishment of the hotel. The aim of this refurbishment is to increase the competitiveness of City Hotel Limited in the market. It is estimated that each room will be refurbished at a cost of £5,000. The total cost of the entire hotel is estimated at £2,500,000. The management anticipates that the refurbishment will increase occupancy by 5%.
The third option is leasing out 100 hotel rooms to Yamamadori for a period of five years. The company will rent the entire top floor. However, Yamamadori will require adjustments to be made to the rooms. The adjustments are expected to cost $5,000 per room. Thus, the total capital expenditure per room will amount to £10,000. Further, Yamamadori requires a reduction in price per room since they will engage their own staff members to service to rooms.
The fourth option will combine both the option of refurbishing the entire hotel and renting out the entire floor of the hotel to Yamamadori. Therefore, it will combine the second and the third option.
Yamamadori room price reduction recommendation
The prices for Yamamadori should take into account both the prevailing market rates. This can be attributed to the fact that if the price offered doesn’t reflect the market rates, then the City Hotels Limited may lose the business to the competitors in the regions. Also, the management should take into account the costs of renovating the rooms. The price charged should be able to cover the total renovation cost of £10,000 that will spread over a period of five years.
The cost is approximated at £30 per day. This comprises of the cost of renovation and depreciation, other fixed costs of running the hotel. Thus, the break-even point of each hotel room is £30. This is the point at which price charged for each room can cover both the fixed and variable costs (Ross, Westerfield & Jordan 2008). After taking into account the cost of capital and profit, the most sustainable price per room is £45.
Summary of results
The table presented below shows a summary of the results of evaluation of the four options discussed above.
|Items||Capital cost||ARR||Payback period||NPV||IRR|
|Option 1 – reduction of price per room||0||–||–||–||–|
|Option 2 – refurbish hotel||2,500||44.6%||2.8 years||£6,587.42||27%|
|Option 3 – Yamamadori contract||1,000||97.6%||1 year||£7,310.13||86%|
|Sensitivity test option 3||1,000||76.0%||1.5 years||£6,714.50||65%|
|Option 4 – refurbishment + Yamamadori||3,000||53.3%||2.3 years||£7,619.93||37%|
|Sensitivity test option 4||3,500||39.5%||2.3 years||£6,524.29||23%|
Discussion of results
In the table, if the company continues to operate in its current state. Then the net present value will be £5,249.18. The results of calculations of contribution margin for the first option are presented in appendix 1 below. The calculations show that the option is not viable because the total contribution reduces as price per hotel room drops. In the case of the second option, the accounting rate of return is 44.6%, while the internal rate of return is 27%. Further, the option yields a payback period of 2.8 years.
The resulting NPV is £6,587.42. The third option has the shortest payback period of 1 year with a high value of the accounting rate of return (97.6%) and IRR of 86%. The NPV value is also high at £7,310.13. A sensitivity analysis carried out on the third option shows that the ARR and IRR can drop to 76% and 65% respectively.
The length of the payback period also increases to 1.5 years. The NPV can also drop to a low of £6,714.50. The fourth option generates ARR and IRR of 53.3% and 37% respectively. The payback period of this option is 2.3 years (Melicher & Leach 2009). This option has the highest value of NPV at £7,619.93.
A sensitivity analysis carried out on the fourth option shows that the NPV can drop to £6,524.29. The ARR and IRR can drop to 39.5% and 23% respectively. The payback period will remain the same. Thus, the results show that option 4 has the highest NPV value while the third option has the highest value of ARR and IRR and a low value of the payback period (McLaney & Atrill 2008).
Get your first paper with 15% OFF
Discussion of sensitivity test and risk assessment
Sensitivity analysis and risk assessment are vital because they give information on how the forecasted result can change when there are changes in the business environment (Brigham & Ehrhardt 2010).
The changes can either be positive or negative. Therefore, it is important to carry out sensitivity analysis and risk assessment where a company experiences uncertainty in some values. The results of sensitivity analysis for the second and the third option are presented in table 1 above. The sensitivity analysis focuses on the worst case scenarios (Dayananda, Irons, Harrison, Herbohn & Rowland 2002).
Based on the discussion above, the company should select option 3 because it yields a high value of ARR, IRR, and NPV before and after the sensitivity analysis. The option also generates a low payback period. However, this option is based on acceptance by Yamamadori. The second best alternative is option three. The third best alternative is option 2 because it will yield a higher NPV than the current state.
Brigham, F & Ehrhardt, M 2010, Financial management theory and practice, Cengage Learning, United States of America.
Dayananda, D, Irons, R, Harrison, S, Herbohn, J, & Rowland, P 2002, Capital budgeting: Financial appraisal of investment projects, The Press Syndicate of the University of Cambridge, United Kingdom.
McLaney, E & Atrill, P 2008, Financial accounting for decision makers, Prentice Hall, United States.
Melicher, R & Leach, C 2009, Entrepreneurial finance, Cengage Learning, United States of America.
Powell, G & Baker, H 2005, Understanding financial management: A practical guide, Blackwell Publishing, Australia.
Ross, S, Westerfield, R & Jordan, B 2008. Fundamentals of corporate finance, McGraw-Hill Publishing Company Limited, USA.