Question

Paradise Ltd is a Special Purpose Vehicle set up to venture into the tourism sector. It has recently purchased an uninhabited island, close to the popular resort of Chilubi, at a cost of K2 million. The company has already spent K1·5 million on preparing the land for construction work. Over the next year it plans to develop the island extensively, with the aim of making it one of the most exclusive holiday locations in the region.

 

An offer has just been made to buy the land for K5 million. Paradise Ltd has therefore decided to reappraise the project in order to decide whether they should still proceed with the project, or should instead accept the offer. If they decide to accept the offer, the sale will take place immediately, incurring legal fees of K20,000. If they reject the offer, development will continue and accommodation will be available for rent in one year’s time.

 

The company’s project accountant has provided estimates of costs and revenues for the next five years as set out below.

 

1. Total construction costs for the seven hotels on the island are K37 million. Of the total, K2 million has already been spent in the form of down payments to several construction firms. These down payments are irrecoverable.

2. Total construction costs for the forty luxury self-catering lodges that will be attached to the hotels are K24 million. A down payment of K4 million is required immediately.

3. The cost of furnishing the hotels and lodges is estimated at K3·2 million.

4. Each lodge will have its own private swimming pool. The cost of each pool is expected to be K12,000.

5. Six restaurants will be built on the island at a cost of K15 million. Paradise Ltd has already had to commit to K3 million of these costs in order to attract the chefs it requires. Although these monies have not yet been paid over, Paradise Ltd is contractually bound to pay them, irrespective of whether the project now proceeds.

6. A small parade of shops will be developed at a cost of K4 million.

7. Annual cash overheads are expected to be K2 million for the hotels. Revenues for the hotels are estimated at K13 million per annum.

8. Maintenance costs for each of the lodges will be K7,000 per annum, compared to rental income of K390,000 per annum, per lodge.

9. Depreciation totaling K1·5 million per annum will be charged in Paradise Ltd’s accounts for the hotels, lodges, restaurants and shops.

10. The restaurant and shops are expected to generate net income of K4·73 million per annum, in total.

11. Interest on money borrowed to finance the project will be K2·5 million per annum.

 

All the set-up costs will occur within the next year, before the resort is open. The annual revenues and overheads relate to the four years following this. Assume that all cash flows occur at the end of each year, unless otherwise stated, and that there are no terminal values to consider at the end of the four years.

The company’s cost of capital is 10% per annum.