Greetings Inc. stores, as well as the Wall Dcor division, have enjoyed healthy prof- itability 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 companys rate of return has exceeded the industry average during this two-year period. Greetings store managers likened the e-business leverage cre- ated by Wall Dcor to a high-octane fuel to supercharge the stores profitability. This high rate of return (ROI) was accomplished even though Wall Dcors 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 Dcor. 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 Dcors success gained widespread industry recognition. The business press documented Wall Dcors approach to using information technology to increase profitability. The companys 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 Dcor. 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 com- petitive 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 companys recent success has led shareholders to expect the stores to gener- ate an above-average rate of return. Mr. Burns is very concerned about how the stores and Wall Dcor 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 groups discussion, the focus turned to the most expensive component of the existing business modelthe large inventory of prints that Wall Dcor has in its centralized warehouse. In ad- dition, Wall Dcor incurs substantial costs for shipping the prints from the cen- tralized 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 Dcor 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 Dcor, the cost of prints to Greetings stores would decrease, thus allowing the stores to sell prints at a lower price than com- petitors. 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 cus- tomers 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 per- form a financial analysis of this proposal. The team has collected the information presented in Illustration CA 4-1.

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 Dcor 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 sug- gested that you do a sensitivity analysis assuming all costs are 10% higher than ex- pected 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 Dcor management and (b) a suggestion on how Greetings stores could use the computer connection for related sales.