As the November Meeting approaches, CFO Doug Scovanner is faced with the problem of choosing which of the five controversial projects available to accept. Our task is to assume this role and evaluate each of the projects based upon two major criteria. The first is determining the firm’s financial motives by quantifying the projected value added to the firm and the risk associated with each project. When determining to accept or reject projects based upon adding value, the most helpful instruments we have are Net Present Value (NPV) and the Internal Rate of Return (IRR).
As we consider capital constraint problems, we also use the Profitability Index in order to determine which projects add the most value per dollar spent. Some key drivers behind this decision criterion include projected sales figures, speculated variations in these sales projections, and the impact that adding a new store into the trade area has on the sales of surrounding stores. The second criterion involved in analyzing the projects is determining the firm’s business motives. This deals with recognizing Target’s corporate goals and mission and how they accomplish this through their business strategy.
Two of the greatest aspects of their strategy are a high value on brand awareness and a defined target market of college educated women with a family. The ultimate goal, therefore, is finding a healthy balance between these two criteria by integrating as much of Target’s business strategy into the fundamental financial goals of wealth maximization shared by all firms. Analysis It has already been established that the vast majority of projects that make it to this stage of the analysis have been considered to be profitable endeavors.
Therefore, the main goal from this point forward is to consider how much of a sacrifice we’re willing to make from our financial goals in order to establish Target’s optimal position strategically. This not only considers the potential sales figures, but also the impact the arrival of a new store would have on competition, both friendly (other Target stores), and rival (Wal-Mart). Based upon the NPV of the base case scenario of all the projects, we would accept them all, but with differing levels of confidence in their potential value.
Therefore, with the current capital budget, we decided to rank and evaluate them in order of the projects with the least evidence supporting the investment to most. As a guideline to our rankings, we used an average of their rankings in several various categories in order to weigh both the financial objectives and business specific objectives. Goldie’s Square – Ranked 5th Goldie’s Square has been established as a hot spot as far as strategic location is concerned; however, the financial requirements must take precedence over establishing the brand in this case.
Referring to our Evaluation Sheet, Goldie’s ranks last in every profitability method and scenario. In addition to its low NPV, it is also the only project that would yield a negative NPV in response to a 10% decrease in sales. Furthermore, the existing forecasted sales alone wouldn’t even be enough to sustain a guaranteed competitive existence in the market. This is supported by a negative NPV of cash flows generated by the store alone. If the credit sales are overstated, even the base case NPV could be a negative value, thus making the investment even more risky.
Of the five potential investments, this is the only one we would actually reject flat out whether budget constraints were an issue or not. Therefore, we also would strongly recommend against funding this project with additional debt or equity as well. Gopher Place – Ranked 4th Gopher Place is the smallest trade area of the investment sites, but it is also the fastest growing. If we are focusing primarily on our profitability measures, it ranks higher than both the Stadium remodel project and the Whalen Court project.
This especially holds true if we are operating in a scenario where we overstate our projected sales values. There are two main reasons that these figures cannot be trusted independently. The first is that a high percentage of the sales figures are at the expense of our own stores. The Gopher Place location would be responsible for stealing 19% of its business from other Target stores in the area. This cannibalization problem indicates another unattractive aspect of the project, which is that the brand is already sufficiently established in the trade area.
With the highest density of Target stores per potential customers, adding another store would flood the market. In addition, Gopher Place also ranks last in the target market of the middle class, college educated family. Yet, regardless of the drawbacks from a strategic standpoint, the financial outlook and potential for growth cannot be denied. We therefore would accept this project under normal circumstances, but would not issue additional debt or equity in order to undertake the development of Gopher Place. The Stadium Remodel – Ranked 3rd
The initial perception of remodeling the Stadium location is that is not a worthwhile investment. This store has already been remodeled twice since its opening, and sales still have reportedly been slumping. However, a quick analysis of its projected cash flows proves that it is indeed worth the hassle. Although there is no projected sales growth after the initial stimulation from the remodel, the increase in sales bests the prototype by nearly $20 million. This directly impacts the projected NPV of the project as almost 95% of the cash flows are derived from this boost in sales.
In addition to the financial support, remodeling the Stadium location also fits well with their business strategy. Some of the key supporting evidence includes a high percentage of the target market in the trade area at 42% of college educated adults, and a population with the highest median income of the group at $65,931. Most important to Target however, would be the maintenance of their brand. As a company that places a high value on the image of their brand, revitalizing a lagging store would both keep their presence in the local area and potentially draw more customers to an upgraded location.
The final decision would be to accept the project under no budget constraints, but not issue new debt or equity to achieve it. Whalen Court – Ranked 2nd The obvious concern regarding the Whalen Court project is the large initial investment required to get it off the ground. Of this cost, the most pressing financial concern is the requirement of leasing the building as opposed to building and owning its own store. As a result, our measures of profitability are not as attractive due to the high costs of doing business in an urban environment. This is reflected in how it measures up to the prototype Target store.
Although the sales generated absolutely crush the prototype sales, the total net investment exceeds that of the prototype by $90 million. However, we’ve already established that this is a rare opportunity and out of the normal arena for Target. They’re presented with the ability to gain a major strategic stronghold while generating the highest NPV among the proposed projects. The decision to invest in the Whalen Court site is further supported by the high percentage of the target market within the trade area; and although the density is rather high, the opportunity to establish a presence in the proposed location is worth it.
It may even be worth closing an under performing store in order to make room to launch a flagship store in the heart of trade area in which they already dominate. This project would therefore be accepted under normal circumstance. Moreover, Whalen Court is the first project that we suggest Target make adjustments in their capital structure if needed in order to finance its development. The Barn – Ranked 1st Of all the projects, the Barn is by far the most attractive.
It requires the lowest initial investment, and offers the second highest NPV of the investment opportunities. Based upon our composite rankings, the Barn ranks fist on all but two measures. Although it has one of the lowest target market percentages in the trade area, it is also a new entrant into the market arena. In comparison to the prototype store, this location beats it in every aspect. In addition, even if the sales are overestimated by 10%, it not only beats the prototype, but also yields the highest NPV of the proposed projects.
Finally, the Barn also fits well with corporate strategy, as it is able to capture a sizable market share in a relatively large trade area. Under these considerations, this project should be accepted under any and all circumstances. Budget Constraints In the hypothetical circumstance that the allocated budget for these new projects were only $150 million as opposed to the $200 million actually provided in the case, we would forced to use another measure of profitability to determine which projects yield the highest return on investment per dollar.
The Profitability Index measures this by dividing the return on investment by the initial investment needed to yield the returns. Although this method is useful in decision making under capital constraints, it is an overall inefficient way of accepting or rejecting projects because it completely ignores the actual scale of the return. If we made this decision based solely upon the profitability index, we would be forced to accept all projects with the exception of the Whalen Court project. We know, however, this would drastically compromise Target’s overall business strategy.
Considering their strategy, it would be most wise to accept the Whalen Court project regardless of the profitability index. After making this decision based solely on corporate strategy, we could then use the P/I in order to determine how we would allocate the remaining $30. 7 million. Using the P/I, only two of the remaining projects are able to be included in Target’s asset allocation. As supported by our Evaluation Sheet, The Barn and The Stadium projects yield the highest amount of return per dollar invested, and should therefore be included in Target’s asset allocation.
The result of the profitability index test provides additional supporting evidence that the rankings based on the projected cash flows are accurate as well. In closing, Target’s investment decision has been a crucial example of the importance of balancing financial objectives with strategic objectives of the company. Though NPV and IRR may support an investment on paper, it is also critical to analyze the market environment, and make decisions that will support growth in the long run and not simply satisfy the potential short term financial gains.