I need an answer to question #4 for the business situation -Greetings Inc. stores as well as the Wall Décor division haveenjoyed healthy profitability during the last two years.... In aone page memo, provide a recommendation based on the NPVanalysis.....
Greetings Inc.: Capital Budgeting
The Business Situation
Greetings Inc. stores, as well as the Wall Décor division, haveenjoyed healthy profitability
during the last two years. Although the profit margin on printsis often
thin, the volume of print sales has been substantial enough togenerate 15% of
Greetings’ store profits. In addition, the increased customertraffic resulting from
the prints has generated significant additional sales of relatednon-print products.
As a result, the company’s rate of return has exceeded theindustry average during
this two-year period. Greetings’ store managers likened thee-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 WallDécor’s
venture into e-business proved to cost more than originallybudgeted. Why was it
a profitable venture even though costs exceeded estimates?Greetings stores were
able to generate a considerable volume of business for WallDécor. This helped
spread the high e-business operating costs, many of which werefixed, across
many unframed and framed prints. This experience taught topmanagement that
maintaining an e-business structure and making this businessmodel successful
are very expensive and require substantial sales as well ascareful monitoring of
costs.
Wall Décor’s success gained widespread industry recognition. Thebusiness
press documented Wall Décor’s approach to using informationtechnology to
increase profitability. The company’s CEO, Robert Burns, hasbecome a frequent
business-luncheon speaker on the topic of how to use informationtechnology to
offer a great product mix to the customer and increaseshareholder value. From
the outside looking in, all appears to be going very well forGreetings stores and
Wall Décor.
However, the sun is not shining as brightly on the inside atGreetings. The
mall stores that compete with Greetings have begun to offerprints at very competitive
prices. Although Greetings stores enjoyed a selling priceadvantage for a
few years, the competition eventually responded, and now thepressure on selling
price is as intense as ever. The pressure on the stores isheightened by the fact that
the company’s recent success has led shareholders to expect thestores to generate
an above-average rate of return. Mr. Burns is very concernedabout how the
stores and Wall Décor can continue on a path of continuedgrowth.
Fortunately, more than a year ago, Mr. Burns anticipated thatcompetitors
would eventually find a way to match the selling price ofprints. As a consequence,
he formed a committee to explore ways to employ technology tofurther reduce
costs and to increase revenues and profitability. The committeeis comprised of
store managers and staff members from the informationtechnology, marketing,
finance, and accounting departments. Early in the group’sdiscussion, the focus
turned to the most expensive component of the existing businessmodel—the
large inventory of prints that Wall Décor has in its centralizedwarehouse. In addition,
Wall Décor incurs substantial costs for shipping the prints fromthe centralized
warehouse to customers across the country. Ordering andmaintaining
such a large inventory of prints consumes valuableresources.
One of the committee members suggested that the company shouldpursue
a model that music stores have experimented with, where CDs areburned in the
store from a master copy. This saves the music store the cost ofmaintaining a
large inventory and increases its ability to expand its musicofferings. It virtually
guarantees that the store can always provide the CDs requestedby customers.
Applying this idea to prints, the committee decided that eachGreetings store
could invest in an expensive color printer connected to itsonline ordering system.
This printer would generate the new prints. Wall Décor wouldhave to pay a royalty
on a per print basis. However, this approach does offer certainadvantages. First,
it would eliminate all ordering and inventory maintenance costsrelated to the
prints. Second, shrinkage from lost and stolen prints would bereduced. Finally,
by reducing the cost of prints for Wall Décor, the cost ofprints to Greetings stores
would decrease, thus allowing the stores to sell prints at alower price than competitors.
The stores are very interested in this option because it enablesthem to
maintain their current customers and to sell prints to an evenwider set of customers
at a potentially lower cost. A new set of customers means evengreater
related sales and profits.
As the accounting/finance expert on the team, you have beenasked to perform
a financial analysis of this proposal. The team has collectedthe information
presented in Illustration CA 4-1.
Illustration CA 4-1
Information about the proposed capital investment project
Available Data | Amount |
Cost of equipment (zero residual value) | $800,000 |
Cost of ink and paper supplies (purchase immediately) | 100,000 |
Annual cash flow savings for Wall Décor | 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 |
Instructions
Mr. Burns has asked you to do the following as part ofyour 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 toooptimistic. 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 inthe analysis, and identify
the risk(s) associated with purchasing the equipment.
4. In a one-page memo, provide a recommendation based on theabove analysis.
Include in this memo: (a) a challenge to store and Wall Décormanagement and (b) a
suggestion on how Greetings stores could use the computerconnection for related
sales.
