Question

Joan Chris is the Denver district manager of Stale-Mart, an old established chain of more than 100 department stores. Her district contains eight stores in the Denver metropolitan area. One of her stores, the Broadway store, is over 30 years old. Chris began working at the Broadway store as an assistant buyer when the store first opened, and she has fond memories of the store. The Broadway store remains profitable, in part because it is mostly fully depreciated, even though it is small, is in a location that is not seeing rising property values, and has had falling sales volume. Stale-Mart owns neither the land nor the buildings that house its stores but rather leases them from developers. Lease payments are included in “operating income before depreciation.” Each store requires substantial leasehold improvements for interior decoration, display cases, and equipment. These expenditures are capitalized and depreciated as fixed assets by Stale-Mart. Leasehold improvements are depreciated using accelerated methods with estimated lives substantially shorter than the economic life of the store. All eight stores report to Chris, and, like all Stale-Mart district managers, 50 percent of her compensation is a bonus based on the average return on investment of the eight stores (total profits from the eight stores divided by the total eight-store investment). Investment in each store is the sum of inventories, receivables, and leasehold improvements, net of accumulated depreciation. She is considering a proposal to open a store in the new upscale Horse Falls Mall three miles from the Broadway store. If the Horse Falls proposal is accepted, the Broadway store will be closed. Here are data for the two stores (in millions of dollars):

Broadway (Actual) Horse Falls (Forecast)

Average inventories and receivables during the year     $2.100 $2.900

Leasehold improvements, net of Accumulated depreciation 0.900 4.600

Operating income before depreciation   1.050 3.300

Depreciation of leasehold improvements 0.210 1.425

Assume that the forecasts for Horse Falls are accurate. Also assume that the Broadway store data are likely to persist for the next four years with little variation. Stale-Mart finds itself losing market share to newer chains that have opened stores in growth areas of the cities in which they operate. The rate of return on Stale-Mart stock lags that of other firms in the retail department store industry. Its cost of capital is 20 percent. REQUIRED 1. Calculate the return on total investment and residual income for the Broadway and Horse Falls stores. 2. Chris expects to retire in two years. Do you expect her to accept the proposal to open the Horse Falls store and close the Broadway store? Explain why or why not. 3. Offer a plausible hypothesis supported by facts in the problem that explains why Stale-Mart is losing market share and also explains the poor relative performance of its stock price. What changes at Stale-Mart would you suggest to correct the problem? Be as comprehensive and objective as you can in your recommendations, providing pros and cons to your recommendations.

Answer 1

1. Calculation of ROI and Residual income  

	(Millions in dollars)
	Broadway (Actual)	Horse falls (Forecast)
Operating income	$ 1.050	$ 3,300
less: Depreciation	0.210	1.425
Net income	$ 0.840	$ 1.875
Investment
Inventories and receivable	$ 2.10	$ 2.90
Fixed asset	0.90	4.60
Total investment	$ 3.00	$ 7.50
ROI	28%	25%
Net income	$ 0.840	$ 1.875
Less: Cost of capital (20%)	(0.600)	1.500
Residual income	$ 0.240	$ 0.375

2. I expect Ms. Chris to reject the proposal and keep the Broadway store open. She will do this to maximize her bonus compensation, not necessarily because of her emotional attachment to the Broadway store. From the calculations in part (a), the Broadway store has a higher ROI (28 percent) than the Horse Falls store (25 percent). Her bonus is based on ROI and opening the Horse Falls store lowers her average ROI across the eight stores.

3. Her decision to keep the Broadway store open will change if residual income is used to measure performance. Residual income of the Horse Falls store is higher than the residual income of the Broadway store.

Stale-Mart's loss of market share and poor stock price performance is likely due to their unwillingness to open new stores in growing areas of cities and closing stores in declining areas of cities. The demographics of cities change over time and once profitable locations stagnate as affluent shoppers move residences to newer areas. Retailers must move with their customer base.
Stale-Mart does not appear to be doing this. The performance evaluation and reward systems encourage district managers to keep old stores open beyond the store's prime. Once the leasehold improvements have been mostly depreciated the store's accounting ROI then looks very good.

Stale-Mart has several options to correct this problem:

i. Remove the decision rights to open new stores from the district managers and give it to corporate managers who are compensated on share price appreciation. The problem with this option is that the district managers likely have better-specialized knowledge of their local markets than the corporate staff.
ii. Change the performance evaluation system of the district managers. Calculate the performance of each district manager based on operating income before depreciation. But then you have to control their incentive to over-invest in leasehold improvements. Alternatively, calculate depreciation on the straight-line method using longer lives. This reduces the penalty for opening new stores.
iii. Base bonuses on residual income, not ROI. If incentive plans are based on maximizing ROI, this creates incentives to under-invest or divest of projects that earn above their cost of capital but below the division's average ROI. Residual income does not suffer from this problem.