1. just answer Recommended strategy Deluxe Corporation is a large chain of retai
ID: 2795748 • Letter: 1
Question
1. just answer Recommended strategy
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.
Your PowerPoint represents a presentation to the Board of Directors of Deluxe Corporation
The following return analysis should be used: Net Present Value and Internal Rate of Return.
Prepare a Sensitivity risk analysis with three variables of your choosing. Your margins of variance are plus/minus 10%, 20%, 30%. Your Sensitivity work should include a graph analysis.
Corporate tax is 25%.
Ignore inflation.
Explanation / Answer
The discounting rate is taken to be 9% because the project is riskier. Investigation fees of $100,000 is sunk cost and is to be excluded from our NPV and IRR calculations.
Present Value of Outflows at Year 0
6.89
Since NPV is positive, the company should execute the marketing strategy.
Calculation of IRR
IRR is the rate at which present value of cash outflows equal the present value of cash inflows.
Hence solving the below equation,
46 = [11.70/(1+r)] + [12.63/{(1+r)^2}] + [28.57/{(1+r)^3}] ,
we get, r = 6.27%
If the required rate of return of the company is less than 6.27%, then it should execute the marketing strategy. Else, the same can be dropped.
However, since, NPV is positive, there is no harm for the company in going forward with the strategy.
I would broadly help you out in Sensitivity Analysis now. Please take three variables of your liking.
Eg.Discounting Rate to be changed to 9.9% (10% increase)
Now your present value of cash inflows would be
Year 1 ------> 11.60
Year 2 ------> 12.42
Year 3 ------> 27.87
Accordingly NPV would be 51.90 - 46 = 5.90
Change in NPV for 1% change in discounting rate = (6.89 - 5.90)/ 6.89 * 100 = 14.37%
Hence for 10% change in discounting rate, NPV is 14.37% sensitive.
The discounting rate is taken to be 9% because the project is riskier. Investigation fees of $100,000 is sunk cost and is to be excluded from our NPV and IRR calculations.
Present Value of Outflows at Year 0
Fixed Assets 30.00 WC 16.00 Total 46.00 Calculation of Depreciation Cost of Fixed Assets 30.00 Residual Value 3.00 Useful Life 3.00 Depreciation p.a. 9.00 Present Value of Cash Inflows Year 1 Year 2 Year 3 Earnings 14.00 17.00 22.00 (Less) Depreciation p.a. 9.00 9.00 9.00 EBT 5.00 8.00 13.00 (Less) Tax @ 25% 1.25 2.00 3.25 Earnings after tax 3.75 6.00 9.75 (Add) Depreciation p.a. 9.00 9.00 9.00 Cash Flow after tax 12.75 15.00 18.75 Residual Value of Fixed Asset 3.00 (Less) Book Value of Fixed Asset - Cash profit on sale of Fixed Asset 3.00 (Less) Tax @ 25% 0.75 Profit after tax on sale of Fixed Asset 2.25 Net Working Capital into business after 3 years 16.00 Total Cash Flows 12.75 15.00 37.00 Discount Factor @ 9% 0.9174 0.8417 0.7722 Present Value of Cash Inflows 11.70 12.63 28.57 Calculation of NPV Present Value of Cash Inflows of all 3 years 52.89 Present Value of Cash Outflow at Year 0 46.00 NPV6.89
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