Sunny Hotels plc owns a successful chain of hotels. The company is considering diversifying its activities through the construction of a theme park near Reduit. Thetheme park would have a mixture of family activities and adventure rides. Sunny hasjust spent Rs400,000 on market research into the theme park, and is encouraged bythe findings.
The theme park is expected to attract an average of 1,500 visitors per day for at least four years, after which major new investment would be required in order to maintain demand. The price of admission to the theme park is expected to be Rs180 per adult and Rs100 per child. 60% of visitors are expected to be children. In addition to admission revenues, it is expected that the average visitor will spend Rs80 on food and drinks, (of which 30% is profit), and Rs50 on gifts and souvenirs, (of which 40% is profit). The park would open for 360 days per year.
Except for maintenance, construction costs and the realisable value of fixed assets, all other costs and receipts are shown at current prices and are expected to rise by 3% per year from current values. The theme park would cost a total of Rs400 million and it will take one year before the construction is fully complete. The park would become operational at the start of year 2. Half of the Rs400 million would be payable immediately, and thereafter half in one year's time. In addition working capital of Rs50 million will be required from the end of year one.
The realisable value of fixed assets is expected to be Rs357.14 million after four years of operation. Maintenance costs (excluding labour) are expected to be Rs15 million in the first year of operation, increasing by Rs4 million per year thereafter. Annual insurance costs are Rs2 million, and the company would apportion Rs2.5 million per year to the theme park from existing overheads. The theme park would require 1,500 staff costing a total of Rs40 million per annum (at current prices).
Sunny will use the existing advertising campaigns for its hotels to also advertise thetheme park. This will save approximately Rs2 million per year in advertisingexpenses.
Required:
Prepare supporting calculations to decide whether or not Sunny should undertake the investment in the theme park given a risk adjusted discount rate of 11.80% per annum.