Question

I need an answer to question #4 for the business situation - Greetings Inc. stores as well as the Wall Décor division have enjoyed healthy profitability during the last two years.... In a one page memo, provide a recommendation based on the NPV analysis.....

Greetings Inc.: Capital Budgeting

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’ 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’ 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

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 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.

Answer 1

Net present Value Analysis
Years	Reference	0	1	2	3	4	5	Total
Inflow
Annual cash flow saving			175000	175000	175000	175000	175000	875000
Additional cash flow			100000	100000	100000	100000	100000	500000
Sale of ink and paper supplies							50000	50000
Total	A		275000	275000	275000	275000	325000	1425000
Outflow
Cost of Equipment		800000						800000
Ink and paper supplies		100000						100000
Total	B	900000	0	0	0	0	0	900000
Net	C=A-B	-900000	275000	275000	275000	275000	325000	525000
Discounting factor @12%	D	1.0000	0.8929	0.7972	0.7118	0.6355	0.5674
Discounted Cash flow	E	-9,00,000.00	2,45,535.71	2,19,228.32	1,95,739.57	1,74,767.47	1,84,413.73	1,19,684.80
NPV								1,19,684.80
As Net present value is positive Purchase of equipment is beneficial.
Sensitivity Analysis
Decreased value of Inflows	F=A*(1-0.10)		247500	247500	247500	247500	292500	1282500
Increased value of Outflows	G=B*(1+0.10)	990000	0	0	0	0	0	990000
Net	H=F-G	-990000	247500	247500	247500	247500	292500	292500
Discounting factor @12%	I	1.00	0.89	0.80	0.71	0.64	0.57
Discounted Cash flow	J=H*I	-9,90,000.00	2,20,982.14	1,97,305.48	1,76,165.61	1,57,290.72	1,65,972.36	-72,283.68
NPV								-72,283.68
Possible flaws in the numbers and assumptions used in this case
1) Better technology in future can short life of current equipment.
2) Cost of Capital should be used on the basis of mode of funding used- capital or loan.
3) Cost of ink and paper supplies not used annually which may be wrong assessment.
4) Residual value of Ink and paper supplies is 50% of original cost which appears to be at higher side.
5) Taxation impact ignored which may give impact on the analysis.
6) Effect of competition can not be assessed by such analysis.

Memo

Challenges for business

Due to enhancement of technologies and spread of strategies globally doing business is now comparatively easier than before but this coin has also another side due to this many business lost their customer base. New technology demands new strategy and cost of doing business. Many a times businessman lost their command over business due to now every one know the secret of business by the help of using online knowledge base. Survival is possible only when you can run with the speed of changing time but how long its depend on various factors. Key factor is how many you observe and taken into consideration for decision making. Every lost factor has its own cost.

Use of Information Technology

Information technology provide important information for businesses as well. Now businesses can get various key information of market, Key analysis without incurring any cost only due to availability of information on fingertips. Every successful person do analysis before taking decision. Decision of any king like purchase, target consumers, process costing or promotion, if any one want to touch success he need to shake hands with technology now.