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Fairfield Office Supplies Inc Fairfield Office Supplies Case -- Spring 2021 Fairfield Office Supplies Inc. has a regional chain of office supply stores in the Midwest. Fairfield is trying to compete with the large nationwide office supply companies. It is January of 2021 and Fairfield needs to make some capital budgeting decisions this year. They need to decide whether to replace their computerized inventory system or upgrade the old one, whether to purchase two stores from a sole proprietor or not, whether to keep, abandon or modernize one of the stores, which new copiers to purchases and a few other small projects. The company is under some pressure and has a strict capital budget of $11 million, so they need to be careful as to which projects they choose. Examine the following book-value balance sheet for Fairfield Office supplies for the year 2016. What is the capital structure of the firm based on market values? The preferred stock currently sells for $5.75 per share and the common stock for $17.00 per share. The preferred stock pays a dividend of $.65 per share, the Common Stock paid a dividend of $1.10 last year, and the firm is expected to continue to grow at the same rate as the net income for the past five years, The rate on 90 day treasuries is 1.90%, the beta of the stock is 1.5, the market risk premium is 8%, and the firm’s tax rate is 40%. The float costs are as follows: Debt: 10% of par, preferred: $0.5 per share and Common: $2.00 per share. The firm has paid out 25% of its net income as dividend in the past five years and is expected to continue. If the company borrows over $1.0 million then the cost of debt goes from 10.0% to 12.5% (including flotation) and if the company borrows over $2 million the cost goes to 14% (including flotation). Find the Marginal costs of capital for Fairfield. Fairfield tax rate is 40%. (For Required return of retained earnings use an average of the DCF method and the CAPM method). Book Value Balance Sheet for 12/31/20 (all values in millions) Assets Liabilities and Net Worth Cash and short-term securities $1.5 Bonds, coupon =9.0%, paid $14.0 Annually (maturity = 15 years, Current yield to maturity = 10.0%) Accounts Receivable 3.0 Preferred stock (par value $4 3.0 Per share) Inventories 6.0 Common Stock (par value $.5) 1.50 Plant and equipment 35 Additional paid in stockholders’ 8.75 Capital Retained Earnings 18.25 Total $45.5 Total $45.5 Years 2020 2019 2018 2017 2016 Net Income (in millions) 5.00 4.75 4.30 4.00 3.78 Projects: 1. Replacement or upgrade of the computerized inventory system: The current system is 3 years old, originally cost $1,000,000, is being depreciated on a straight-line basis over its five year life and has an estimated salvage value of $100,000. Although the system is being depreciated over 5 years, it could last for 5 more years. If the machine was sold today, it would be for $330,000. The new system would cost $1,300,000, including installation costs, and would be depreciated on a straight-line basis over its five year life to a salvage value of $300,000. Fairfield spent $100,000 last year researching this new system. This new system would reduce cash operating costs by $290,000 per year. Inventory needs are expected to increase by $80,000 immediately due to the new system, but accounts payable will rise by $20,000. At the end of the life of this machine inventory and accounts payable will reverse. Both machines will be sold at their salvage value at the end of the five year project. Should the company recommend replacement or upgrade the system? 2. Purchase two store from a sole proprietor: Listed below are the two stores and the projected sales volume for their next fiscal year. Sam’s Office SupplySam’s Too $1,600,000$1,300,000 Fairfield feels the recent annual sales volume is a good basis for projecting its volume. Management feels there is a 40% probability that the stores will do the projected volume, a 30% probability that they will do 10% more sales volume and a 30% probability that they will do 10% less volume than projected. Using the projected sales volume (from above) as the projected first year’s sale volume. Fairfield anticipates generating an annual growth rate of 3% per year after that. Each store has five years left on their respective leases, and Fairfield feels that each store will require remodeling costs of $150,000 immediately upon purchase of the stores. The stores will also require an investment of new inventory of $200,000 in each store. They also felt that it is not wise to retain the existing inventory, as it is not indicative of the quality merchandise representative of Fairfield’s image. They have determined that the inventory would bring $0.20 for every retail dollar existing in the five stores and would be realized immediately upon purchase. It is estimated that the total retail value of inventory in both stores is $750,000. No tax effect of inventory liquidation need be contemplated. Fairfield estimates that its Gross profit will be approximately 60% of sales, its operating expenses will be 30% of sales and its support overhead at 10% of sales. Depreciation, which is not included in the operating expenses, is estimated to be $95,000 per year. The owner is seeking $1,600,000 for all the assets and rights under the respective leases. The $1,900,000 ($1,600,000 cost and $300,000 of remodeling) will be depreciated using straight line method over a 20 year life to a salvage value of zero. It is expected that the stores could be resold for 120% of expected sales in year 5. Should Fairfield undertake the acquisition? What is the Coefficient of Variation? If the Coefficient of Variation indicates that this is a high risk project and if high risk projects should have 2.5% added to the WACC, then should this project be accepted? (Assume in the final analysis that this is a high risk project and 2.5% should be added to the WACC.) 3. Keep, Modernize or Abandon store Fairfield is considering abandoning a store with no debt. Fairfield believes they could sell the store for $325,000 after taxes or it could be kept and it will produce after-tax cash flows of $95,000 for each of 5 years. In addition, the possibility of modernizing the store with additional after-tax cash flow consequences solely for the modernization are as follows: 012345 $68,000$12,000$21,000$22,000$20,000$18,000 Should Fairfield abandon, keep or modernize? 4. Purchase of copy machine Fairfield is considering two alternative copy machines to purchase. Fairfield will need to purchase three machines for each of its thirty stores. Machine A has an expected life of 4 years, will cost $27,000, and will produce net cash flows of $12,500 per year. Machine B has an expected life of 8 years, will cost $32,000 and will produce net cash flows of $10,000 per year. Fairfield plans to operate the machines for 8 years. Inflation is expected to be zero and depreciation is already taken into account in the cash flows. Which new machine should Fairfield purchase? 5. Other Projects There are a few other projects Fairfield is looking at: · Purchase parcels of land to put future stores on: $4.2 million that is expected to be worth $12.6 million in 10 years. · Purchase of New business line: Cost= $4 million, Net after tax cash flow for the next 5 years = 1.2 million and the Business is expected to net $5.0 million when sold after 5 years. · Purchase of a supplier: Cost $3.1 million, Net after tax cash flow for the next 6 years = $1.0 million, this includes the benefits of the lower cost of goods, and the business is expected to net $3.0 million when sold after 6 years. 6. Decision time. Which projects would you suggest that Fairfield act upon if no capital rationing and what is the optimal capital budget AND taking into consideration the $11 million capital rationing which projects would suggest Fairfield act upon? Your answer should outline in detail, including back up spread sheets and any appropriate graphs (use exhibits), why you are or are not suggesting each project. All work must be shown. If you need to make any assumptions please make them clear. Also, remember you are to work on this project alone.