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Capital Budgeting in a Retail Establishment Home Made Inc, stores, as well as the Wall Art 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 Home Made' 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 r turn has exceeded the industry average during this two-year period. Home Made' store managers likened the ebusiness leverage created by Wall Art to a "high-octane" fuel to supercharge the stores" profitability. This high rate of return (ROI) was accomplished even though Wall Art's venture into e-business proved to cost more than originally budgeted. Why was it a profitable venture even though costs exceeded estimates? Home Made stores were able to generate a considerable volume of business for Wall Art. This helped spread the high ebusiness 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. Wail Art's success gaincd widespread industry recognition. The business press documented Wall Art's approach to using information technology to increase profitability. The company's CEO, Christine Patton, 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 Home Made stores and Wall Art. However, the sun is not shining as brightly on the inside at Home Made. The mall stores that compete with Home Made have begun to offer prints at very competitive prices. Although Home Made 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. Ms. Patton is very concerned about how the stores and Wall Art can continue on a path of continued growth. Fortunately, more than a year ago, Ms. Patton anticipated that competitors would eventually find a way to mateh the selling price of prints. As a consequence, she 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 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 Art's success gained widespread industry recognition. The business press documented Wall Art's approach to using information technology to increase profitability. The company's CEO, Christine Patton, 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 Home Made stores and Wall Art. However, the sun is not shining as brightly on the inside at Home Made. The mall stores that compete with Home Made have begun to offer prints at very competitive prices. Although Home Made 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. Ms. Patton is very concerned about how the stores and Wall Art can continue on a path of continued growth. Fortunately, more than a year ago, Ms. Patton anticipated that competitors would eventually find a way to match the selling price of prints. As a consequence, she 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. Barly 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 Art has in its centralized warehouse. In addition, Wall Art 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 Home Made store could invest in an expensive color printer connected to its online ordering system. This printer would generate the new prints. Wall Art 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 Art, the cost of prints to Home Made 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 below. Instructions Ms. Patton 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. (Tab 1) 2. Ms. Patton is concerned that the original estimates may be too optimistic. She has suggested that you do a sensitivity analysis (re-run your calculations) assuming all costs are 10% higher than expected and that all inflows are 10% less than expected. (Tab 2) 3. Identify possible flaws in the numbers or assumptions used in the analysis, and identify the risk(s) associated with purchasing the equipment, then make a recommendation to Ms. Patton based on your analysis. (Tab 3: Maximum two paragraph discussion. Grammar and readability are very important.) Deliverables (1 file for Part B): Instructions Ms. Patton 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. (Tab 1) 2 Ms. Patton is concerned that the original estimates may be too optimistic. She has suggested that you do a sensitivity analysis (re-run your calculations) assuming all costs are 10% higher than expected and that all inflows are 10% less than expected. (Tab 2) 3. Identify possible flaws in the numbers or assumptions used in the analysis, and identify the risk(s) associated with purchasing the equipment, then make a recommendation to Ms. Patton based on your analysis. (Tab 3: Maximum two paragraph discussion. Grammar and readability are very important.) Deliverables (1 file for Part B): Your file name should include your first initial and last name. (1) Numbers 1- 3 above in an Excel file, 3 tabs (two with calculations, one with your discussion). All work should be clearly labeled with solutions easy to identify