Greetings Inc. Capital Budgeting THE BUSINESS SITUATION Greetings Inc. stores, as well as the Wall Dcor division, have enjoyed healthy profitability…

Greetings Inc.:Capital BudgetingTHE BUSINESS SITUATIONGreetings Inc. stores, as well as the Wall Décor division, have enjoyed healthy profitability during thelast two years. Although the profit margin on prints is often thin, the volume of print sales has beensubstantial enough to generate 15% of Greetings’s store profits. In addition, the increased customertraffic resulting from the prints has generated significant additional sales of related non-print products.As a result, the company’s rate of return has exceeded the industry average during this two-yearperiod. Greetings’s store managers likened the e-business leverage created by Wall Décor to a “highoctane”fuel to supercharge the stores’ profitability.This high rate of return (ROI) was accomplished even though Wall Décor’s venture into e-businessproved to cost more than originally budgeted. Why was it a profitable venture even though costsexceeded estimates? Greetings stores were able to generate a considerable volume of business for WallDécor. This helped spread the high e-business operating costs, many of which were fixed, across manyunframed and framed prints. This experience taught top management that maintaining an e-businessstructure and making this business model successful are very expensive and require substantial sales aswell as careful monitoring of costs.Wall Décor’s success gained widespread industry recognition. The business press documented WallDécor’s approach to using information technology to increase profitability. The company’s CEO,Robert Burns, has become a frequent business-luncheon speaker on the topic of how to use informationtechnology to offer a great product mix to the customer and increase shareholder value. From theoutside looking in, all appears to be going very well for Greetings stores and Wall Décor.However, the sun is not shining as brightly on the inside at Greetings. The mall stores that competewith Greetings have begun to offer prints at very competitive prices. Although Greetings storesenjoyed a selling price advantage for a few years, the competition eventually responded, and now thepressure on selling price is as intense as ever. The pressure on the stores is heightened by the fact thatWileyPLUS 2/27/10 9:26 AM Page 2 of 3pressure on selling price is as intense as ever. The pressure on the stores is heightened by the fact thatthe company’s recent success has led shareholders to expect the stores to generate an above-averagerate of return. Mr. Burns is very concerned about how the stores and Wall Décor can continue on apath of continued growth.Fortunately, more than a year ago, Mr. Burns anticipated that competitors would eventually find a wayto match the selling price of prints. As a consequence, he formed a committee to explore ways toemploy technology to further reduce costs and to increase revenues and profitability. The committee iscomprised of store managers and staff members from the information technology, marketing, finance,and accounting departments. Early in the group’s discussion, the focus turned to the most expensivecomponent of the existing business model—the large inventory of prints that Wall Décor has in itscentralized warehouse. In addition, Wall Décor incurs substantial costs for shipping the prints from thecentralized warehouse to customers across the country. Ordering and maintaining such a largeinventory of prints consumes valuable resources.One of the committee members suggested that the company should pursue a model that music storeshave experimented with, where CDs are burned in the store from a master copy. This saves the musicstore the cost of maintaining a large inventory and increases its ability to expand its music offerings. Itvirtually guarantees that the store can always provide the CDs requested by customers.Applying this idea to prints, the committee decided that each Greetings store could invest in anexpensive color printer connected to its online ordering system. This printer would generate the newprints. Wall Décor would have to pay a royalty on a per print basis. However, this approach does offercertain advantages. First, it would eliminate all ordering and inventory maintenance costs related to theprints. Second, shrinkage from lost and stolen prints would be reduced. Finally, by reducing the cost ofprints for Wall Décor, the cost of prints to Greetings stores would decrease, thus allowing the stores tosell prints at a lower price than competitors. The stores are very interested in this option because itenables them to maintain their current customers and to sell prints to an even wider set of customers ata 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 ofthis proposal. The team has collected the information presented in Illustration CA 4-1.Illustration CA 4-1 Information about the proposed capital investment projectEXERCISESWileyPLUS 2/27/10 9:26 AM Page 3 of 3InstructionsMr. Burns 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 ofthe year.2 Mr. Burns is concerned that the original estimates may be too optimistic. He has suggested that you do asensitivity analysis assuming all costs are 10% higher than expected and that all inflows are 10% less thanexpected.3 Identify possible flaws in the numbers or assumptions used in the analysis, and identify the risk(s) associatedwith purchasing the equipment.4 In a one-page memo, provide a recommendation based on the above analysis. Include in this memo: (a) achallenge to store and Wall Décor management and (b) a suggestion on how Greetings stores could use thecomputer connection for related sales

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