Explain whether we should accept this project or not. It should also include an analysis of the project over various possible cost and growth assumptions.

You currently work for a major, national retail chain. Your stores offer everything from food and clothing to electronics, sporting goods and landscaping materials. However, your companys growth has significantly slowed in recent years due to increased competition and market saturation. Senior management has identified some new areas of opportunity, one of which they want your group to analyze. While your stores carry home improvement materials and basic tools, they are in no way competing directly against some of the big box, full-service retailers such as Lowes or Home Depot. While you have no interest in trying to match their full line of items for sale, you do think that there is a great deal of potential in creating a store to compete for contractors business by offering construction materials at a very low price. Given your national footprint and market dominance, you have the ability to negotiate the lowest costs from suppliers of any firm in the business. Since builders and contractors look for low prices and high volumes, you think that you have an opportunity to seriously penetrate this market. So beginning next year (2013), management would like to run market testing in five metropolitan areas, to analyze the profit potential for this new business. In each of the areas, we intend to rent a vacant, big-box facility of at least 8,000 square feet. It is anticipated that this will cost us $1,250,000 per year for the four years the test will continue. Also, we will need to purchase two medium duty electric forklifts for each of the stores, at a price of $28,000 per unit. These will be depreciated using a 7-year MACRS schedule, and will have a resale value of $16,000 at the end of the project. We will also invest $100,000 (20K per unit) for initial advertising and incentives in the five markets. We expect that our sales from the five stores will be $6,000,000 in the first year, and we will incur variable expenses of 70% which includes labor, materials, and all other operating expenses. At the beginning of the project, we will need to build-up our initial inventory, and we expect that it will be 10% of our predicted annual sales in the next year. We will carry accounts receivable, which will be 30% of our annual sales on average. Also, we will be able to take account of our strong buying power to get good credit terms from our suppliers, and expect our accounts payable to represent 25% of our total expenses. Finally, we expect that these new units will cut into our existing store sales by $100,000 per year after-tax. Your expected tax rate is 30%. While most of our numbers are fairly clear, we are uncertain about two numbers. First, how quickly will our project grow over the next four years? We expect that revenues will grow by an average of 10% each year, with our most optimistic growth rate being 20% per annum. However, given the uncertainty in the real estate market, there is a chance they could decrease by as much as 20% per year. We also know that our variable expense could be anywhere from 65% of sales to as much as 75% of sales. Your final analysis should consider the sensitivity of your project estimates to various possible growth and expense rates.

To finance this project, the company expects to use 60% debt and 40% equity. You understand that this project will clearly be more risky than your own firms operations, and therefore, you cannot use their cost of equity in analyzing this project. Instead, you will select three pure-plays in the construction supply industry, and download their returns to calculate each of their betas. You will then de-lever their betas to get an estimate of a typical industry unlevered beta. You will then re-lever that beta based on your own debt to equity ratio, and use the resulting project specific beta in estimating the cost of equity for the project. For cost of debt, you will analyze the average yield to maturity on four year, A rated bonds. Again, the lower rating relative to your own companys will compensate for the increased risk. Assume that that market return over the next four years will average 8%, and use the current risk-free rate to estimate your cost of equity.

Explain whether we should accept this project or not. It should also include an analysis of the project over various possible cost and growth assumptions.