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Management is critical to the success of any business venture (Talluri & Ryzin 2005). This proposal addresses the low-occupancy problem at City Hotel Limited by selecting the most suitable choice from the available alternatives. This proposal also evaluates the possible outcomes of adopting various investments options.
Objectives of the Project to be Undertaken
The objectives of this project include:
- Carrying out a financial evaluation of alternative options to improve the hotel’s profitability.
- Determining the profitability of accepting a proposed contract with a Japanese firm.
- Undertaking a risk assessment of the various alternatives.
- Making recommendations of the alternatives assessed.
Options to be Evaluated
Continuing to Run the Hotel in its Current Format
This option will assume that the hotel’s profitability will decrease due to forecast reduction in room occupancy levels of 5% each year for the next five years.
Refurbishing the Hotel
Refurbishing the hotel will cost £2.5 million. The expected increase in occupancy will be estimated at 5%, which will be assumed to be constant for the next five years.
Leasing the Hotel for Five Years
The firm can consider leasing 100 rooms to the Japanese staff for five years because it guarantees a five-year income. The leasing of rooms only means that the hotel will not have salaries to cater for thus reducing overhead costs. The capital investment cost of this option is £1m.
Introducing Weekend Discounts
The use of weekend discounts will assume that discounts will attract clients and increase room occupancy.
Profit and Loss Accounts
The profit and loss accounts for the various alternatives will be used to determine the most viable alternatives. The variable cost of the rooms will be determined by apportioning the total cost and adding to the additional cost of refurbishing the rooms according to the specifications of the Japanese firm. The total cost will be determined by adding the depreciation. The total costs will be used to consider the price to be charged.
Effects of Discounts on Room Occupancy
The effect of discount on room occupancy will be determined by comparing the hotel occupancy and income at various process points of £50 per room, £45 per room, £40per room and £35 per room.
Investment Appraisal Methodology
Accounting Rate of Return (ARR)
The accounting rate of return conveys the profits obtained from a venture as a percentage of the preliminary capital cost (Röhrich 2007). The main benefit of ARR is its straightforwardness, which makes it easy to comprehend. Its similarity to commonly employed measures such as the average rate of return and the fact that it is stated as a percentage make it easier for managers to use.
However, ARR does not consider the duration of the project or the scheduling of cash flows all through the project. Additionally, the perception of profit is prejudiced and varies with different accounting practices as well as the capitalisation of project costs. Consequently, the computation of ARR for similar ventures may yield different results from business to business. Also, ARR does not provide managers with a clear indicator to guide their decision regarding making an investment or not.
Payback period is the duration needed for cash influxes from a capital investment project to level the cash outlays. Companies can decide between contending projects by undertaking the project with the shortest payback period. Its main advantage is its simplicity. It is useful in a business environment involving quick technological transformations where new machinery require replacement within a short time and a fast reimbursement on investment is vital. Its shortcomings include a lack of objectivity when it comes to deciding the length of ideal payback time. Also, cash flows are considered either pre-payback or post-payback. However, cash flows are rarely considered post-payback.
Net Present Value
Net present value considers the time value of money. Cash influxes anticipated in coming years are reduced back to their present-day value. A discount rate that is equal to the possible interest obtained from the sum had it been saved or the interest payable by the company on borrowed funds are used in the computation. A positive NPV indicates that the venture is viable because the cost of securing the firm’s capital is reimbursed by the resulting cash influxes. The project with the highest NPV should be chosen when evaluating several competing projects.
Internal Rate of Return
The internal rate of return depicts the yearly percentage profit realized by a project where the sum of the discounted cash influxes in the course of the entire project is equivalent to the total capital invested. The IRR is also seen as the rate of interest that diminishes the NPV to zero.
From the above appraisal methodologies, the net present value is the best method to use because it provides a distinct criterion to use when deciding a viable project.
Cost of Capital
From a stockholder’s viewpoint, this is the anticipated rate of earnings on a firm’s existing securities. It is used as a minimum rate of return in investment appraisal to ensure that the venture does not run operate at a loss.
Methodology to Determine Contract Price for Japanese Firm
Market Price Consideration
The company will decide on its prices by considering the market rates in the region. The presence of competitive prices of similar hotels in the region will force the hotel to come up with a price that reflects the value provided by the hotel.
Cost Price Considerations
The firm will use the estimated expenses to decide on the overall profitability (Hales & Van Hoff 2009). For example, the firm will meet the renovation costs at £10,000 a room, which will be distributed over the five-year period. The total cost will be approximately £30 per day including the renovation cost of £5.56 a room, £2.77 depreciation, and £22.22 (all calculated on a day to day basis). The £30 will be a breakeven point. Considering the cost of capital and profits, sustainable room charges will be estimated at £45.
A range of sensitivity test will be undertaken to assess the risk associated with possible variations in the forecast assumptions. Key assumptions to be tested will include occupancy levels, capital investment costs and the Japanese contract room price. The evaluation of risk will be done by considering the dangers and benefits of all alternatives. For example, the contractual agreement will minimize the risk of renovation. The surety that the 100 rooms will be occupied will allow the hotel to source capital for renovations. The benefits of discounts will be realized in the form of increased room occupancy, which may not be the case for renovations (Tranter, Stuart-Hill, & Parker 2011). Therefore, the alternative with fewer risks will be considered ultimately.
Conclusion and Recommendation
The final decision will be made by considering the benefits to be attained from the refurbishment of the entire hotel, leasing part of it to the Japanese and reducing the daily charges. The choice with the potential to yield the largest profit margins revenues at a low cost will then be recommended. According to Kimes and Wirtz (2003), revenue management by reinvestment in hotel businesses will be preferable to capital borrowing because of its profitability.
Hales, J. A. & Van Hoff, H. B 2009, Accounting and financial analysis in the hospitality industry, Prentice Hall, Upper Saddle, NJ.
Kimes, S. E. & Wirtz, J 2003, ‘Has revenue management become acceptable? Findings from an international study on the perceived fairness of rate fences,’ Journal of Service Research, vol.6, no.2, pp. 125–135.
Röhrich, M 2007, Fundamentals of investment appraisal: an illustration based on a case study, Oldenbourg Verlag, München, Germany.
Talluri, K. T. & Ryzin, G. J. V 2005, The theory and practice of revenue management, Springer, New York.
Tranter, K. A., Stuart-Hill, T., & Parker, J 2011, An introduction to revenue management for the hospitality industry: principles and practices for the real world, Prentice Hall, New Jersey.
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