Deluxe Corporation is a large chain of retail stores operating in the USA. It sells top-of the-range, expensive clothes to a wealthy clientele throughout the country. Currently, Deluxe only operates in the USA. Its current market capitalization is $760 million, and the current market value of debt is $350 million.
At last month’s management meeting the marketing director explained that sales volume had increased slightly in the previous year, largely due to heavy discounting in most of its stores. The finance director expressed concern that such a strategy might damage the image of the company and reduce profits over the longer term.
An alternative strategy to increase sales volume has recently been proposed by the marketing department. This would involve introducing a new range of clothing specifically aimed at the middle-income market. The new range of clothing would be expected to be attractive to consumers in Canada and Europe.
Assume you represent the financial management of Deluxe and have been asked to evaluate the marketing department’s proposal to introduce a new range of clothing. An initial investigation into the potential markets has been undertaken by a firm of consultants at a cost of $100,000 but this amount has not yet been paid. It is intended to settle the amount due in three months’ time. With the help of a small multi-department team of staff you have estimated the following cash flows for the proposed project:
- The initial investment required would be $46 million: This comprises $30 million for fixed assets and $16 million for net current assets (working capital).
- For accounting purposes, fixed assets are depreciated on a straight-line basis over three (3) years after allowing for a residual value of 10%.
- The value of net current assets at the end of the evaluation period can be assumed to be the same as at the start of the period.
- Earnings before taxes are forecast to be $14 million in 2018, $17million in 2019 and $22 million in 2020.
- The proposed project is to be evaluated over a three-year time horizon. The firm uses Net Present Value and Internal Rate of Return methods to evaluate projects.
- Deluxe usually evaluates its investments using an after-tax discount rate of 8%. The proposed project is considered to be riskier than average and so a risk-adjusted rate of 9% will be used for this project.
- Corporate tax is 25%.
- Ignore inflation.
- Prepare a Sensitivity Risk Analysis with the following variables: Earnings Before Taxes, Project Discount Rate, and Tax Rate. Your margins of variance are plus/minus 10%, 20%, 30%. Your Sensitivity work should include a graph analysis.
- What would you recommend provide capital budget analysis, risk analysis, SWOT analysis, as part of your evaluation?
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