Question

Said Al Hamli and his friend Khaled Al Masri are the owners of a small hotel, the Sun Star, in the Red Sea town of Hurghada. Close to Cairo, the resort town has grown from a fishing village to one of Egypt’s famous vacation spots. Hurghada is the gateway to many small islands and offshore reefs favored by recreational snorkelers and divers and many tourists combine their stay with excursions to the Nile Valley, the Great Pyramids and Luxor.

To take advantage of the growing numbers of tourists, particularly from Europe and the Middle East, Said and Khaled are planning to double the room capacity of their hotel by adding a second building to the already existing structure. Fortunately, Said recognized the great potential of Hurghada ten years ago, well before the town became a hub for recreational tourism, and bought the land adjacent to the hotel for relatively little money when it was still under construction.

Now, Said and Khaled are studying the new layout and trying to determine if the expected revenues justify the substantial initial investment of EGP 70 million ($11.8 million). According to their calculations, operating cost would rise by EGP 23.8 million ($4 million) in the first year, which would include hiring and training of new personnel, maintenance of facilities and equipment etc., and likely increase by about 5 percent per year thereafter. With an aggressive marketing strategy, Said and Khaled believe that a revenue enhancement of EGP 20.8 million in the first year is realistic and that a subsequent annual increase of about 15 percent for eight to nine years, with revenues leveling off thereafter, can be achieved. Ideally, Khaled would like to retire in ten years. Seeking advice from you, a knowledgeable friend, they share their detailed cost and revenue projections with you.

Year	Cash (EGP)	Revenue (EGP)
0	−70,000,000
1	−23,800,000	20,825,000
2	−24,990,000	23,949,000
3	−26,239,000	27,541,000
4	−27,551,000	31,672,000
5	−28,929,000	36,423,000
6	−30,375,000	41,887,000
7	−31,894,000	48,169,000
8	−33,489,000	55,395,000
9	−35,163,000	63,704,000
10	−36,922,000	73,259,000

QUESTIONS

1.	Determine the resulting net cash flow for each year; and compute: a. the net present value, b. the simple payback period, c. and the profitability index.
2.	Give your decision on each result in terms of the project’s expected profitability and Khaled’s ten-year investment horizon

Answer 1

	Note: Since the rate of return is not disclosed in the question the same is considered 5% for the purpose of computation
Year	Cash (A)	Revenue (B)	PV factor (C )	Present Value of Inflows (D) = (B) x (C )	Present Value of Outflows	Net cash flows	Cumulative Cash flows
0	(70,000,000)		1.00	-	(70,000,000)	(70,000,000)	(70,000,000)
1	(23,800,000)	20,825,000	0.95	19,833,333	(22,666,667)	(2,975,000)	(72,975,000)
2	(24,990,000)	23,949,000	0.91	21,722,449	(22,666,667)	(1,041,000)	(74,016,000)
3	(26,239,000)	27,541,000	0.86	23,790,951	(22,666,235)	1,302,000	(72,714,000)
4	(27,551,000)	31,672,000	0.82	26,056,633	(22,666,276)	4,121,000	(68,593,000)
5	(28,929,000)	36,423,000	0.78	28,538,374	(22,666,628)	7,494,000	(61,099,000)
6	(30,375,000)	41,887,000	0.75	31,256,724	(22,666,293)	11,512,000	(49,587,000)
7	(31,894,000)	48,169,000	0.71	34,232,809	(22,666,470)	16,275,000	(33,312,000)
8	(33,489,000)	55,395,000	0.68	37,493,516	(22,666,673)	21,906,000	(11,406,000)
9	(35,163,000)	63,704,000	0.64	41,064,166	(22,666,383)	28,541,000	17,135,000
10	(36,922,000)	73,259,000	0.61	44,974,671	(22,666,905)	36,337,000	53,472,000
	Total			308,963,627	(296,665,197)	53,472,000
	Net present Value = Present Value of Inflows - Present Value of Outflows
		= 308,963,627-296,665,197
	(EGP)	12,298,430
	Decision: Since, through above computation NPV is positive hence the project is viable for investment.
	Simple Payback Period
	To find out pay back period, follow following steps:
	Step 1: We must pick the year in which the outflows have become positive. In other words, the year with the last negative outflow has to be selected. So, in this case, it will be year 9.
	Step 2: Divide the total cumulative flow in the year in which the cash flows became positive by the total flow of the consecutive year.
	So that is, 17,135,000/28,541,000 = 0.60
	Step 3: Step 1 + Step 2 = The payback period is 9.60 years.
	Decision: Since, the above projects almost takes 9.60 years to recover money which is a long horizon.
	Profotibility Index = Present Value of Inflows/Present Value of Outflows
		= 308,963,627/296,665,197
	(EGP)	1.04
	Decision: Since, the profitability index is around 1 the project is viable for investment.