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capital budgeting

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The Business Situation

Greetings Inc. stores, as well as the Wall Décor division, have enjoyed healthy profitability during the last two years. Although the profit margin on prints is often thin, the volume of print sales has been substantial enough to generate 15% of Greetings's store profits. In addition, the increased customer traffic resulting from the prints has generated significant additional sales of related non-print products. As a result, the company's rate of return has exceeded the industry average during this two-year period. Greetings's store managers likened the e-business leverage created by Wall Décor to a "high-octane" fuel to supercharge the stores' profitability.

This high rate of return (ROI) was accomplished even though Wall Décor's venture into e-business proved to cost more than originally budgeted. Why was it a profitable venture even though costs exceeded estimates? Greetings stores were able to generate a considerable volume of business for Wall Décor. This helped spread the high e-business operating costs, many of which were fixed, across many unframed and framed prints. This experience taught top management that maintaining an e-business structure and making this business model successful are very expensive and require substantial sales as well as careful monitoring of costs.

Wall Décor's success gained widespread industry recognition. The business press documented Wall Décor's approach to using information technology to increase profitability. The company's CEO, Robert Burns, has become a frequent business-luncheon speaker on the topic of how to use information technology to offer a great product mix to the customer and increase shareholder value. From the outside looking in, all appears to be going very well for Greetings stores and Wall Décor.

However, the sun is not shining as brightly on the inside at Greetings. The mall stores that compete with Greetings have begun to offer prints at very competitive prices. Although Greetings stores enjoyed a selling price advantage for a few years, the competition eventually responded, and now the pressure on selling price is as intense as ever. The pressure on the stores is heightened by the fact that the company's recent success has led shareholders to expect the stores to generate an above-average rate of return. Mr. Burns is very concerned about how the stores and Wall Décor can continue on a path of continued growth.

Fortunately, more than a year ago, Mr. Burns anticipated that competitors would eventually find a way to match the selling price of prints. As a consequence, he formed a committee to explore ways to employ technology to further reduce costs and to increase revenues and profitability. The committee is comprised of store managers and staff members from the information technology, marketing, finance, and accounting departments. Early in the group's discussion, the focus turned to the most expensive component of the existing business model?the large inventory of prints that Wall Décor has in its centralized warehouse. In addition, Wall Décor incurs substantial costs for shipping the prints from the centralized warehouse to customers across the country. Ordering and maintaining such a large inventory of prints consumes valuable resources.

One of the committee members suggested that the company should pursue a model that music stores have experimented with, where CDs are burned in the store from a master copy. This saves the music store the cost of maintaining a large inventory and increases its ability to expand its music offerings. It virtually guarantees that the store can always provide the CDs requested by customers.

Applying this idea to prints, the committee decided that each Greetings store could invest in an expensive color printer connected to its online ordering system. This printer would generate the new prints. Wall Décor would have to pay a royalty on a per print basis. However, this approach does offer certain advantages. First, it would eliminate all ordering and inventory maintenance costs related to the prints. Second, shrinkage from lost and stolen prints would be reduced. Finally, by reducing the cost of prints for Wall Décor, the cost of prints to Greetings stores would decrease, thus allowing the stores to sell prints at a lower price than competitors. The stores are very interested in this option because it enables them to maintain their current customers and to sell prints to an even wider set of customers at a potentially lower cost. A new set of customers means even greater related sales and profits.

As the accounting/finance expert on the team, you have been asked to perform a financial analysis of this proposal. The team has collected the information presented in Illustration CA 4-1.

Illustration CA 4-1 Information about the proposed capital investment project

cost of equipment(zero residual value) : $ 800,000

cost of ink and paper supplies (purchase immediately) : $ 100,000

Annual cash flow savings for wall decor : $ 175,000

annual additional store cash flow from increased sales : $ 100,000

sale of ink and paper supplies at end of 5 years: $ 50,000

expected life of equipment : 5 years

cost of capital : 12%

Exercises

Instructions
Mr. Burns has asked you to do the following as part of your analysis of the capital investment project.

1 Calculate the net present value using the numbers provided. Assume that annual cash flows occur at the end of the year.

2 Mr. Burns is concerned that the original estimates may be too optimistic. He has suggested that you do a sensitivity analysis assuming all costs are 10% higher than expected and that all inflows are 10% less than expected.

3 Identify possible flaws in the numbers or assumptions used in the analysis, and identify the risk(s) associated with purchasing the equipment.

4 In a one-page memo, provide a recommendation based on the above analysis. Include in this memo: (a) a challenge to store and Wall Décor management and (b) a suggestion on how Greetings stores could use the computer connection for related sales.

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Solution Preview

Dear Student,

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Below are my answers.

ANSWERS

Question 1
Note: The NPV computation is based on the information provided. However, I find it odd that there is no information on the depreciation method and income tax rate.

Year Item Cash Flow PV Factor (12%) NPV
0 Initial investment (800,000) 1.0000 (800,000)
0 Cost of ink and paper supplies (100,000) 1.0000 (100,000)
1 Annual cash flow savings 175,000 0.8929 156,250
1 Additional store cash flows 100,000 0.8929 89,286
2 Annual cash flow savings 175,000 0.7972 139,509
2 Additional store cash flows 100,000 0.7972 79,719
3 Annual cash flow savings 175,000 0.7118 124,562
3 Additional store cash flows 100,000 0.7118 71,178
4 Annual cash flow savings 175,000 0.6355 111,216
4 Additional store cash flows 100,000 0.6355 63,552
5 Annual cash flow savings 175,000 0.5674 99,300 ...

Solution Summary

The NPV computation is examined.

$2.19
See Also This Related BrainMass Solution

Cost of Capital, Capital Budgeting, Capital Structure, Forecasting, and Working Capital Management

Please see attachment use word or excel but please show how you got the answer.

Question 1: (Cost of Capital)

You are provided the following information on a company. The total market value is $38 million. The company's capital structure, shown here, is considered to be optimal.
(see attached file for data)

a. What is the after-tax cost of debt? (assume the company's effective tax rate = 40%)
b. Assuming a $4 dividend paid annually, what is the required return for preferred shareholders (i.e. component cost of preferred stock)? (assume floatation costs = $0.00)
c. Assuming the risk-free rate is 1%, the expected return on the stock market is 7%, and the company's beta is 1.0, what is the required return for common stockholders (i.e., component cost of common stock)?
d. What is the company's weighted average cost of capital (WACC)?

Question 2: (Capital Budgeting)

It's time to decide how to use the money your firm is expected to make this year. Two investment opportunities are available, with net cash flows as follows:
(See attached file for data)

a. Calculate each project's Net Present Value (NPV), assuming your firm's weighted average cost of capital (WACC) is 7%
b. Calculate each project's Internal rate of Return (IRR).
c. Plot NPV profiles for both projects on a graph).
d. Assuming that your firm's WACC is 7%:
(1) If the projects are independent which one(s) should be accepted?
(2) If the projects are mutually exclusive which one(s) should be accepted?

Question 3: (Capital Structure)

Aaron Athletics is trying to determine its optimal capital structure. The company's capital structure consists of debt and common stock. In order to estimate the cost of debt, the company has produced the following table:
(See attached file for data)

The company's tax rate, T, is 40 percent. The company uses the CAPM to estimate its cost of common equity, Rs. The risk-free rate is 1 percent and the market risk premium is 6 percent. Aaron estimates that if it had no debt its beta would be 1.0. (i.e., its "unlevered beta," bU, equals 1.0.)

On the basis of this information, what is the company's optimal capital structure, and what is the firm's cost of capital at this optimal capital structure?

Question 4: (Forecasting)

A firm has the following balance sheet:
(See attached file for data)

Sales for the year just ended were $6,000, and fixed assets were used at 80 percent of capacity. Current assets and accounts payable vary directly with sales. Sales are expected to grow by 20 percent next year, the expected net profit margin is 5 percent, and the dividend payout ratio is 80 percent.

How much additional funds (AFN) will be needed next year, if any?

Question 5: Working Capital Management

The Chickman Corporation has an inventory conversion period of 60 days, a receivables collection period of 30 days, and a payables deferral period of 30 days. Its annual credit sales are $6,000,000, and its annual cost of goods sold (COGS) is 60% of sales.

a. What is the length of the firm's cash conversion cycle?
b. What is the firm's investment in accounts receivable?
c. What is the company's inventory turnover ratio?
d. Identify three ways in which the company could reduce its cash conversion cycle?
e. What are the possible risks of reducing the cash conversion cycle per your recommendations in part d?

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