Office Supplies Fairfield Office Supplies Inc. has a regional chain of office supply stores in the Midwest.

| September 29, 2018

Office Supplies

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 2013 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 $11million,
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 2012. 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 12/31/12
(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

2012

2011

2010

2009

2008

Net Income
(in millions)

5.00

4.75

4.30

4.00

3.78

Projects:

1.
Replacement
of the computerized inventory system with a new 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 of the old system with the
new 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 Supply Sam’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:

0 1 2 3 4 5
$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.

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