This question involves a fictional case study.
Pet Pamper Ltd is a listed company that operates a nationwide retail chain of pet stores. The CEO of the company has approached you (a clever consultant) to provide advice on a number of long-term project proposals.
In a meeting with top management you are told that they are under pressure from major shareholders to maximise share price. Fairly standard stuff, you think. But you are surprised at what you hear next – that the company has no systematic approach to capital budgeting and has never estimated the company’s weighted cost of capital. The task ahead of you starts to fall into place!
The CEO, Don Jones, tells you several projects have been suggested for the coming year. It is these projects on which he seeks your advice. Relevant after tax net cash flows have been estimated for Projects A to D (and are given below) but not for Project E.
This project and the next (Project B) have originated from the executive manager of the company’s distribution centres, Dawn Smith. There is one distribution centre close to each of the major cities, serving all the company’s retail stores in that city. The centres receive deliveries from suppliers (in response to orders from the central office purchasing department), store those goods if required, and ship them to the retail stores as needed.
Dawn wants to improve inventory processing efficiency in the centres. She recognises that this will benefit the company by reducing inventory carrying costs, thereby reducing the investment required in the inventory component of net operating working capital. This will produce an increase in the company’s free cash flows that will continue into the future, given that sales are forecast to grow.
Dawn has identified two alternative systems that could be put in place to achieve this. The alternatives differ significantly in the amount of investment required, which she thinks will give the CEO choice in how far he wants to go with the distribution efficiency drive. The first system (Project A) would cost $5.5 million up front to implement and is then almost guaranteed to provide $4.3 million in cash flow savings in the first year and $0.2 million in the second year. The cash flow savings would then continue to grow roughly in line with the firm’s average sales growth after that. She has estimated this to be equivalent to getting $3.6 million in cash flow savings in the third year.
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This project proposal is Dawn’s alternative system. It requires a much bigger investment than Project A but the cash flow savings are also much bigger because the system will be able to more greatly reduce the time inventories are held. Project B requires an initial investment of $23 million and is then expected to produce cash flow savings of $16 million in the first year, $0.8 million in the second year and, on a similar basis to the estimates made for Project A, the equivalent of $14.5 million in cash flow savings in the third year. You have had a chat with Dawn about her estimates for Projects A and B and feel quite confident that she has made accurate forecasts.
As part of a store refurbishment program, the company has been faced with a vast array of choices in floor coverings. They have narrowed the choices to two (Projects C and D). One of these (Project C) is carpet. It is estimated that carpet purchase and installation will cost $40 per square metre. Ongoing net cash outflows per square metre are estimated to be $21 per year. These cash flows include ongoing cleaning and maintenance costs such as daily vacuuming, twice weekly spot removal and quarterly deep cleaning, as well as tax effects. The carpet is expected to last for 8 years, at which time it will need to be replaced. The CEO was initially concerned about the ongoing costs and longevity of carpet given with the high volume of foot traffic through the stores, including pets that owners are encouraged to bring with them. However, he has full confidence in the estimates after working through them with the facilities manager.
This project is the second floor covering alternative and involves using vinyl flooring in all store refurbishments. Vinyl is longer lasting than carpet and is expected to have a life of 16 years before it needs to be replaced. Purchase and installation will cost $33 per square metre. Ongoing net cash outflows per square metre are estimated to be $24 per year. These higher outflows relate mostly to the need to scrub, strip and seal vinyl, which is more expensive than deep cleaning carpet. The CEO is also confident in these estimates.
Pet Pamper has been in discussions with the developers of a patented shark and crocodile deterring device regarding an adaptation for water-loving dogs. Although very few dogs are actually injured or killed by sharks and crocodiles each year, Pet Pamper believes there is a growing market of caring, risk-averse dog owners that would be interested in such a product. A prototype product for dogs was developed and test marketing undertaken by Pet Pamper with the permission of the developers. The test marketing cost $30,000 and showed that there does indeed appear to be a market for the product. Pet Pamper management is therefore very excited about this new product’s potential.
Moving ahead with the project, however, means that Pet Pamper would have to expand into manufacturing, something the company has not previously done. The developers of the product are not interested in mass production and instead have offered a licensing agreement giving Pet Pamper exclusive rights to manufacture and market the product within the country for a period of 5 years in return for a $5 royalty for each unit sold. Both Pet Pamper and the developers agree that there is unlikely to be a sufficient market for the product beyond 5 years as new technologies are developed.
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If they sign the agreement, Pet Pamper management plans to sell the new product exclusively through the company’s own retail stores. The plan is to sell the devices for $200 per unit (i.e. per device) during the first two years but after that reduce the price by 5% per year as the product life-cycle passes through the maturity and decline stages. The marketing department has estimated unit sales for each year (see table below) but they are very tentative due to the product’s novelty.
Unit Sales 1 175,000
200,000 3 150,000
60,000 5 35,000
Marketing of the product will be needed, particularly in the early years of the project. The focus will be on gaining publicity for the product through social media. However, given the novelty of the product, it is likely to attract significant traditional media coverage as well. The marketing manager expects all this publicity to increase the company’s market share resulting in a benefit of $1.1 million annually (before tax) during Project E’s life. Annual marketing costs related to the project have been estimated as shown in the table below.
Marketing Costs 1 $1,000,000
$600,000 3 $300,000
$300,000 5 $100,000
The company owns a large and currently vacant industrial building that would be suitable for the project’s production facility. The intention was to put this building on the rental market for $1.5 million per year but the CEO has agreed to its use for Project E if the project proposal is accepted.
A consultant was commissioned at a cost of $100,000 to undertake a technical feasibility analysis of product production and give advice on equipment and production costs. This analysis indicated that production equipment costing $25 million will be needed at the beginning of the project and installation of this equipment will cost $500,000. The equipment can be depreciated to zero for tax purposes using the prime cost method over a five year life. The equipment will be sold as parts and metal scrap for $400,000 at the end of this time.