Recommendations to the Restaurant Manager
In the current state, the restaurant is profitable. The break-even point is 89,474 covers with a margin of safety of 10,526 covers, and the net profit is £60,000. This implies that the restaurant sales have to fall, by at least 10,526 covers for it to start making losses. The manager has several considerations to make on measures to improve the profitability of the restaurant. The available options and offers are discussed below.
Reducing the price to £10.00
If the price is reduced to £10.00, there will be a rise in sales to 12,000 covers. The contribution margin will fall from £5.30 to £4.70. The new break-even point will be 108,511 covers with a margin of safety of 11,489 covers. This shows that the marginal of safety will increase hence the strategy is effective in improving the profitability of the restaurant. Incremental analysis indicates that the strategy will lead to an increase in the restaurant’s net profit by £94,000 (Baker & English, 2013).
Increasing the price to £12.00
If the price is increased to £12.00, there will be a reduction in sales to 80,000 covers. The strategy will increase the restaurant’s contribution margin to £6.70. The new break-even point will be 75,821 covers and the margin of safety will 4,179 covers. This shows that the strategy will cause a fall in the restaurant’s margin of safety. The total profit if the price is increased £28,000. This indicates that there will be an incremental loss of £32,000.
The restaurant manager should choose the strategy of reducing the price to £10 since it results in an incremental profit. Raising the price to £12.00 results in an incremental loss thus it should not be pursued.
Hosting 20 weddings
Hosting weddings will not change the fixed costs. Therefore, the incremental analysis considers the variable costs. The price per cover is £15.00 thus the contribution margin will increase to £9.70. With 5000 covers expected, the restaurant will earn an incremental profit of £48,500 if it accepts. The restaurant should agree to host the weddings since they will increase its total profit.
Request for a 5-day conference
Accepting the request will have no impact on the restaurant’s fixed costs. The price per cover will be £8.70, more than the restaurant’s variable cost per cover. This implies that the contribution margin for the offer is positive. Therefore, the request will generate an incremental profit of £10,200 as shown on the spreadsheet.
Investment appraisal techniques
Net present value
It finds the difference between the present values of cash inflows and outflows expected from a project (Baker & English, 2013). It is determined by discounting all the cash flows in each of the years of the project’s economic life. Under this technique, investments will a positive NPV are viable thus are accepted while those with a negative NPV are rejected. Where there are two or more competing projects, the one with the greatest NPV is selected. The technique is beneficial is it takes into account the time value of money. It also includes all the cash flows generated throughout the project’s lifetime. However, it may be difficult to determine the accurate discount rate.
Internal rate of return
It is defined as the discount rate at which the NPV of a project is zero (Moyer, McGuigan, & Kretlow, 2014). It assumes that cash inflows of a project are reinvested at the IRR. It is compared with the firm’s cost of capital to determine whether an investment is viable or not. IF the IRR is greater than the cost of capital, then the project is viable. It is also beneficial since it considers the time value of money and uses all the project’s cash flows. However, it is a relative measure and may give misleading decisions especially when comparing unequal projects.
Payback period
It is determined by dividing the initial cost by the net annual cash flows. It is the period it will take for a project to make sufficient cash flows to cover the project’s initial cost (Brigham & Ehrhardt, 2013). A favorable payback period should be shorter than the project’s useful life. Some organizations have a set payback period which all projects must guarantee. When there are two or more competing projects, the one with the shortest payback period should be selected. Its limitation is that it ignores cash flows arising after the payback period and as well as ignoring the time value of money.
Profitability index
It is the ratio of the total present value of cash inflows and the initial cost. It gives the return in terms of the present value of net cash flows per pound of the initial cost (Atrill, 2013). If a project has a profitability index of more than one, then the project should be accepted. In the case of two or more projects, the project with the largest profitability index is selected. Any project whose PI is less than 1 is not viable and should be rejected.
The net present value is the most appropriate for evaluating investment projects as well as comparing and ranking different projects.
Factors affecting discounting
Factors affecting the discounting of cash flows include the firm’s financial structure, the level of the project’s risks, among other factors. The firm’s capital structure determines the cost of capital which is the discount rate (Moles, 2011). Besides, the discount rate can be adjusted if the project’s level of risk is higher than normal.
Evaluating proposed investments
In this case, we use the NPV to assess the viability of the proposed investments. As shown on the spreadsheet, all the four investment have positive NPVs thus they are all viable. If the hotel has adequate funds, then it can invest in all the four projects (Moyer, McGuigan, & Kretlow, 2014). If funds are limited, the hotel should consider the Pay per view TV since it has the greatest NPV.
References
Atrill, P. (2013). Financial management for decision makers (3rd ed.). Harlow, England: FT
Prentice Hall.
Baker, H. & English, P. (2013). Capital Budgeting Valuation: Financial Analysis for Today's
Investment Projects. Hoboken, N.J.: Wiley.
Brigham, E. & Ehrhardt, M. (2013). Financial Management: Theory & Practice (14th ed.).
New York: Cengage Learning.
Moles, P. (2011). Corporate finance. Hoboken, N.J.: Wiley.
Moyer, R., McGuigan, J., & Kretlow, W. (2014). Contemporary financial management. St.
Paul: West Pub. Co.
