Case 4[*]
Greetings Inc.: Capital Budgeting
The Business Situation
Greetings Inc. stores, as well as the Wall Décor division, have enjoyed healthy profitabilityduring the last two years. Although the profit margin on prints is oftenthin, the volume of print sales has been substantial enough to generate 15% of Greetings’ store profits. In addition, the increased customer traffic resulting fromthe 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 duringthis two-year period. Greetings’ store managers likened the e-business leverage createdby Wall Décor to a “high-octane” fuel to supercharge the stores’ profitability.
This high rate of return (ROI) was accomplished even though Wall Décor’sventure into e-business proved to cost more than originally budgeted. Why was it a profitable venture even though costs exceeded estimates? Greetings stores wereable to generate a considerable volume of business for Wall Décor. This helpedspread the high e-business operating costs, many of which were fixed, acrossmany unframed and framed prints. This experience taught top management thatmaintaining an e-business structure and making this business model successfulare very expensive and require substantial sales as well as careful monitoring ofcosts.
Wall Décor’s success gained widespread industry recognition. The businesspress documented Wall Décor’s approach to using information technology to increase profitability. The company’s CEO, Robert Burns, has become a frequentbusiness-luncheon speaker on the topic of how to use information technology tooffer a great product mix to the customer and increase shareholder value. Fromthe outside looking in, all appears to be going very well for Greetings stores andWall Décor. However, the sun is not shining as brightly on the inside at Greetings. Themall stores that compete with Greetings have begun to offer prints at very competitiveprices. Although Greetings stores enjoyed a selling price advantage for afew 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 thatthe company’s recent success has led shareholders to expect the stores to generatean above-average rate of return. Mr. Burns is very concerned about how thestores 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 ofstore managers and staff members from the information technology, marketing,finance, and accounting departments. Early in the group’s discussion, the focusturned to the most expensive component of the existing business model—thelarge inventory of prints that Wall Décor has in its centralized warehouse. In addition,Wall Décor incurs substantial costs for shipping the prints from the centralizedwarehouse to customers across the country. Ordering and maintainingsuch a large inventory of prints consumes valuable resources.
One of the committee members suggested that the company should pursuea model that music stores have experimented with, where CDs are burned in thestore from a master copy. This saves the music store the cost of maintaining alarge inventory and increases its ability to expand its music offerings. It virtuallyguarantees that the store can always provide the CDs requested by customers.
Applying this idea to prints, the committee decided that each Greetings storecould 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 royaltyon a per print basis. However, this approach does offer certain advantages. First,it would eliminate all ordering and inventory maintenance costs related to theprints. 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 storeswould 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 tomaintain their current customers and to sell prints to an even wider set of customersat 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 informationpresented in Illustration 4-1.
Illustration 4-1 - Information about the proposed capital investment project
. Available Data Amount in Dollars
Cost of equipment (zero residual value) 800,000
Cost of ink and paper supplies (purchase immediately)100,000
Annual cash flow saving for Wall Décor175,000
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 of your analysis of the capital investment project.
- Calculate the net present value using the numbers provided. Assume that annual cash flows occur at the end of the year.
- Mr. Burns is concerned that the original estimates maybe 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.
- Identify possible flaws in the numbers or assumptions used in the analysis, and identify the risk(s) associated with purchasing the equipment.
- 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.
[*]Case developed by Thomas L. Zeller, Loyola University Chicago, and Paul D. Kimmel, University of Wisconsin–Milwaukee