Deluxe Corporation is a large chain of retail stores operating in the USA. It se

Question

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 your 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 2016, $17million in 2017 and $22 million in 2018.

The following information is also relevant:

• 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.

Explanation / Answer

Here, depreciation per annum will be $9,000,000 after considering the salvage value of 10% (of $30million).

Based on available information, total after tax cash flows for three years have been calculated in excel sheet as shown below:

Using this base case, NPV and IRR have been calculated by using the excel formula as NPV(0.09,C16:E16)-B16 for NPV and IRR(B16:E16) for IRR.

Here, B16: E16 are the cash flows values as we calculated in above table.

For sensitivity analysis, we change the value of EBT, discount rate and tax rate by plus/minus 10%, 20% and 30% one by one in above table, then it will change the value of NPV and IRR. It is done in excel sheet. once you change these values, you will automatically get the changed NPV and IRR value (as formula is already inserted there). These are shown below:

Here, few points should be noted.

Depreciable capital $30,000,000 Residual value(10%) $3,000,000.0 Depreciation each year $    9,000,000.0

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