Question

Kike Ltd is a retailer dominance of the athletic shoe and sporting apparel businesses. Kike Ltd, which currently views itself as operating in the sporting wear (shoes and clothes) segment, is considering an expansion into the fashion apparel business, producing high-priced casual clothing for teenagers and young adults. The Company therefore, is contemplating building another new retail store across the town. Followings are information on this expansion. The company already owns the land for this store, which currently has an abandoned warehouse located on it. The land cost at $350,000 and has a useful life of 10 years. Kike Ltd bought this land 5 years ago. The cost of $45,000 for demolishing the abandoned warehouse and clearing the lot. The marketing department spent $20,000 on market research to determine the extent of customer demand of the new segment for the new store. The construction of the new store would cost $500,000, with 5-year life and depreciated using straight line method. The loss of 30% sales in the existing retail outlet (old segment), if customers who previously drove across town to shop at the existing outlet (old segment) become customers of the new store (new segment) instead. Kike Ltd issue bond at 6% to finance the construction cost. Assumes the cost of capital is 10% and tax rate is 27%. Kike Ltd is expecting the sales of the new segment which will be constant at $150,000 per year for 5 years. Required: Discuss should the land cost that has an abandoned warehouse be included as part of incremental earnings for the proposed of new segment. Would the value of land if sold be considered as opportunity cost? Discuss should the cost of $45,000 for demolishing the abandoned warehouse and clearing the lot and the marketing cost of $20,000 be included as part of incremental earnings for the proposed of new segment. Discuss in detail how the cost of the construction of the new store, $500,000, with 5-year life and depreciation using straight line method and the cost of issuing bond at 6% to finance the construction cost are treated as incremental earnings for the proposed of new segment. In the situation where the employees leave the new store sitting idle due to some unavoidable circumstances (such strike, natural disaster), should the cost in (c) is treated as opportunity cost? Discuss in details how this loss of 30% sales in the existing retail outlet (old segment), if customers who previously drove across town to shop at the existing outlet (old segment) become customers of the new store (new segment) instead will impact the incremental earnings for the proposed of new segment. Explain why it is advantageous for Kike to use the most accelerated depreciation method compared to straight line method. Is it realistic for Kike to forecast a constant sale for 5 years? (1 mark)

Answer 1

Working Notes

• Company : Kike - Planning to Expand from its current store and Planning to open another Retail store
• Currently, It owns the Land where it is planning to Build the new store. However, there is an existing warehouse on the land which needs to be demolished for the new construction to take place.
• Cost of Land = $ 350,000 (bought 5 years ago) and its total useful life is 10 years
• Cost of demolishing warehouse: $ 45,000
• Marketing Cost = $ 20,000
• Construction cost of the new Retail store = $ 500,000 (Useful life of 5 yrs, depreciated on a straight Line basis)

Loss that the company will incur in the existing outlet because the existing customers will now move to buy from the new outlet = 30% of sales

Company Raises money by issuing a Bond at 6% interest

Cost of capital = 10%

Tax = 27%

Projected Sales

	Year 1	Year 2	Year 3	Year 4	Year 5
Sales	150000	150000	150000	150000	150000

Lets look at the questions now:

Q1. Discuss should the land cost that has an abandoned warehouse be included as part of incremental earnings for the proposed of new segment. Would the value of land if sold be considered as opportunity cost?

Ans - Incremental earnings is compose of two factors - Incremental revenue and incremental cost. The cost of land will not be included as part of incremental cost and therefore will not form a part of incremental earnings calculation. Any cost that the company has incurred before making a new investment decision will be a sunk cost for the company and is not relevant for the incremental earnings calculation.

Opportunity cost is the income foregone by the firm by not choosing an alternative that would also generate income. The firm can decide to sell the land and get the money and not construct the new outlet. But if in case the company decides to construct the outlet, then it is definitely foregoing the the income it could have generated by selling the land. And the same is the opportunity cost for the firm. This is also equal to the sales price of the land - Taxes the firm would have paid on the proceeds of the property.

Q2.  Discuss should the cost of $45,000 for demolishing the abandoned warehouse and clearing the lot and the marketing cost of $20,000 be included as part of incremental earnings for the proposed of new segment.

Ans. Market research is a part of sunk cost (Cost incurred before the company decided to open the new outlet) so it would not be included in the incremental earnings calculations. But the Cost of demolishing the abandoned warehouse and clearing the lot would be part of the incremental costs as the company would not have incurred this cost if it did not desire to open another store.

Q3. Discuss in detail how the cost of the construction of the new store, $500,000, with 5-year life and depreciation using straight line method and the cost of issuing bond at 6% to finance the construction cost are treated as incremental earnings for the proposed of new segment.

Ans. Incremental costs are the costs that the company incurs as a result of its investment decision. It includes the direct Production costs, Personnel expenses, marketing expenses, material costs. The construction costs are the capital expenditure costs and they will increase the depreciation expenses at the firm. As the construction costs are depreciated yearly on a straight line basis the firm will incur cost of $ 100,000 ($ 500,000 / 5) every year for 5 years. For the debt borrowed at 6% interest - Although this is a finance cost, for capital budgeting purposes, we do not consider the finance costs in the incremental earnings calculation as we want to arrive at an unlevered net earnings.

Q4. In the situation where the employees leave the new store sitting idle due to some unavoidable circumstances (such strike, natural disaster), should the cost in (c) is treated as opportunity cost?

Ans. The cost in (c) will not be an opportunity cost if employees leave as the cost involved in construction of the outlet was not an income for the company that the company decided to forego, it was the cost that the company decided to bear after taking the decision to construct the new outlet.

However, the sales value that the company is losing in this waiting time is an opportunity cost as the firm is losing on its sales as the store is idle and there is no employee working.

Q5. Discuss in details how this loss of 30% sales in the existing retail outlet (old segment), if customers who previously drove across town to shop at the existing outlet (old segment) become customers of the new store (new segment) instead will impact the incremental earnings for the proposed of new segment.

Ans. The customers who will move from the previous store to the new store to shop are not the new customers and are a loss to the first outlet instead. These customers will lead to rise in sales at the new store but at the expense of the sales of the old store. Hence, the loss of 30% in sales at the new store has to be decrease from the sales of the new store in order to calculate the incremental earnings at the new store.

Q6. Explain why it is advantageous for Kike to use the most accelerated depreciation method compared to straight line method.

Ans. In the straight line of depreciation method, the depreciation costs are spread evenly over the useful life of the asset. The accelerated depreciation method will lead to higher depreciation costs in the initial years of the Project and lower depreciation in the later years. Due to this the Business's incremental earnings will be lower in the initial years but higher in the later years. As a result of this, the company will have to pay lower taxes and will save on taxes in the initial years of investments into the new project. As the company is in an expansion phase, it can use this money to re-invest in its business in order to continue the growth and expansion.

Q7. Is it realistic for Kike to forecast a constant sale for 5 years?

Ans. Sales are projected based on the Average selling price and multiplied by the number of expected units sold. It is not realistic, as the sales numbers will vary depending on various factors such as competition, Life cycle of the products, change in fashion (as it is going into fashion clothing line which is highly unpredictable), Popularity etc.