Target’s capital-budgeting system

 

Questions for Advance Assignment to Students

 

1. Be prepared to describe and critique Target’s capital-budgeting system. Give specific consideration to the role of the real-estate managers and the makeup of the CEC.

Target’s capital-budgeting system is composed of three entities: The Real-Estate Managers, the Research and Planning Group (R&P), and the Capital Expenditure Committee (CEC). The approval process for capital budget allocation starts with proposals that are passed on to the real-estate managers, which manage specific geographical regions. The real-estate managers then develop the proposal by gathering and satisfying various details and requirements in order to prepare it for the CEC pitch. The processed proposal would then be sent to R&P. The R&P group would then make use of various demographic and site-specific data in order to generate sales estimates and other forecasts. These estimates would then be compiled with the work of the real-estate managers in order to comprise what Target calls as a “capital-project request dashboard” that would then be reviewed by the CEC, which would either accept or reject the proposal.

Although the system is relatively upfront, the problem lies in the various expenses that were supposedly incurred by the real-estate managers and the R&P group in the preparation and development of the proposals, as well as the so-called “emotional sunk costs” incurred in the inception and development of the proposals. While the firm cannot account for the emotional aspect of the sunk costs, the researchers believe that certain incentives and proposal development reimbursement is required to further boost the rate of Target’s development, especially in the midst of an extremely competitive market. The real-estate managers and R&P personnel involved in the development of a project proposal should be rewarded, and the development of a rejected project noted, for their work in order to facilitate a standard of quality of the proposals that reach the CEC for final assessment.

In 1962, Target’s first store was established in Roseville, Minnesota by the Dayton Company which latter changed its name to Target Corporation in the year 2000. Compared to Wal-Mart which focuses more on low prices of products, Target decided to concentrate more on the shopping experience of the customers which resulted to the good performance of the company in the industry. The Capital Expenditure Committee (CEC) decides whether to approve or decline different Capital Project Requests (CPRs) which may set a criterion that would possibly affect future decisions. The CEC which is composed of 5 executive officers including Mr. Doug Scovanner sets monthly meetings to review and analyze new CPRs that could have a lasting impact on the short-term and long-term profitability of the company. For the month of November 2006, there were a total of 10 CPRs, which represents $300 Million, to be reviewed. However, 5 of them equates to about $200 Million of requested capital which needs the attention of the committee. These projects are Gopher Place, Whalen Court, The Barn, and Goldie’s Square, and Stadium Remodel. To come to a conclusion on whether to approve or deny projects the CEC uses a “dashboard” that has many factors. These factors include total investment size, NPV, IRR, population, population growth, and so on. The problem was where should be the capital be spent on in order to create the most value and the most growth for the company and its shareholders.

 

 

2. Which of the five CPRs should Doug Scovanner accept? Be prepared to explain how each of the considerations that follow influenced your decision:
3. NPV and IRR
4. Size of the project
5. Cannibalization of other stores’ sales
6. Store sensitivities
7. Variance to prototype
8. Customer demographics
9. Brand-awareness impact

 

 

NPV and IRR

 

Project	Investment ($000)	NPV ($000)	IRR
Gopher Place	$23,000	$16,800	12.3%
Whalen Court	$119,300	$25,900	9.8%
The Barn	$13,000	$20,500	16.4%
Goldie’s Square	$23,900	$300	8.1%
Stadium Remodel	$17,000	$15,700	10.8

 

 

Other factors:

 

Project	Advantage	Disadvantage
Gopher Place	● Population expected to grow rapidly by 27% from 2000-2005 ● High NPV at $16,800 ● Second highest IRR between the projects with 12.3% ● High median income of $56,400 ● Low minimum initial investment of $23m	● Wal-Mart competition of 2 additional supercenters ● Low percentage of adults completing 4+ years of college ● Small population
Whalen Court	● Rare opportunity for target to enter the urban center of a major metropolitan area ● Will provide Target major brand visibility and free advertising for all passersby because of dense foot traffic and high fashion appeal ● Free advertising ● Large population	● Requires massive investment of $119,300 with uncertain returns ● Property is only under a lease contract ● Store design is different from the typical layout ● Low IRR valued at 9.8%
The Barn	● Will provide Target with a new market since the nearest Target stores are 80 and 90 miles away ● Produces  highest NPV at $20,500 despite low investment ● New market for Target since other stores were 80-90 miles away ● Highest IRR out of the individual projects with 16.4% ● Low initial investment of $13m	● The small rural environment implies a limited market size ● Returns might be short-term ● Changes and updates needed in the short-term
Goldie’s Square	● Area has an affluent and fast-growing population ● High percentage of adults have completed 4+ years of college ● The area was considered a key strategic anchor for many retailers	● $317,000 NPV and 8.1% IRR; lowest among the CPRs ● 45.1% of sales needed for NPV to match the prototype ● Highest number of competitors in the area
Stadium Remodel	● Easier upgrade to a Superstore since the property is already company-owned ● Strong long-term location ● Highest median HH Income from all the projects	●       Second lowest NPV between the projects with $15.7M ●       Third lowest IRR between the projects with 10.8% ●       Sales decline and deteriorating facilities might affect brand image

 

 

 

 

 

 

 

 

 

Exhibits 7 and 8 were used to rank the corporation’s individual projects:

 

 

FINANCIAL RANKING:

 

            NPV

 

Project Name	NPV	Rank
Gopher Place	$16,800	3
Whalen Court	$25,900	1
The Barn	$20,500	2
Goldie’s Square	$300	5
Stadium Remodel	$15,700	4

 

 

            IRR

 

Project Name	IRR	Rank
Gopher Place	12.3%	2
Whalen Court	9.8%	4
The Barn	16.4%	1
Goldie’s Square	8.1%	5
Stadium Remodel	10.8	3

           

           

 

 

 

 

 

 

 

 

 

 

Decline in Sales

 

Project Name	NPV	% Change in NPV	10% Sales Decline	NPV- 10% Sales Decline	Rank
Gopher Place	$16,800	-28.11%	-$4,722	$12,078	2
Whalen Court	$25,900	-63.14%	-$16,611	$9,289	4
The Barn	$20,500	-19.83%	-$4,066	$16,434	1
Goldie’s Square	$300	-1357.67%	-$4,073	-$3,773	5
Stadium Remodel	$15,700	-50.03%	-$7854	$7846	3

 

 

            Given the rankings made above, we can determine the ranking that each individual project will be worth if Scovanner were to venture into these investments.

 

For 1st place, Scovanner should invest in The Barn due to the fact that this investment yields a high NPV with a very low initial investment and it is located in a relatively new market. This is a good opportunity for Target to get a large market share in that area in case no similar stores of similar reputation have ventured there. Based on the projections, this project will be the most profitable for Target.

 

In 2nd place, Scovanner should invest in Gopher Place because of its good NPV and high expected return. Also the minimum initial investment is low and the company could generate it. It is also situated in a rapidly growing market which means that they can expect their sales to increase more.

 

In 3rd place, Scovanner should invest in Stadium Remodel because it has been around for long and the decline in sales could be attributed to the fact that its facilities are outdated.  Remodeling it would surely bump its deteriorating sales and not just that the company is just simply proving to the customers that they could still satisfy their needs. The project also has a sensible NPV and IRR given an average investment cost.

 

In 4th place, Scovanner can next invest in Whalem Court. NPV looks considerable but one has to take into account the amount of initial investment put into this project. It makes NPV look small if you consider a $119M initial investment. However, it is situated in a heavily populated area so this might be profitable if demographic growth continues to slant upward. Also large population means that it is very inevitable that people would start talking and telling others about the company.

 

Goldie’s Square should not be an option for investment because it is centered in a competitive area. With JCPenny, Circuit City, Borders and Bed Bath & Beyond situated in the area, this will yield Goldie’s Square a weak NPV because around half of its sales will be rivaled by its surrounding competitors.

 

 

 

3. Why does Target use different hurdle rates for the store sales and the credit cards (9% and 4%, respectively)? What process would you use to estimate these discount rates to see if they are reasonable?

The need for multiple hurdle rates simply addresses the differences in the risk of individual projects and differences in the risk of corporate divisions. The basic notion is that the higher the risk of the project, the higher the hurdle rate should be. In the situation of Target, the use of multiple hurdle rates to determine the net present value of future cash flows accounts not only the time value of money but also the risk of future cash flows. As the corporation assigns discount rates of 9% for the store sales and 4% for the credit cards sales, it was done so to represent the different costs of capital for funding store operations versus funding credit card receivables, as it was mentioned in the case. It also accounts for the amount of bad debts that were empirically observed over the various Target stores’ occupation. Moreover, not all of the expected income from the credit cards can be guaranteed; thus, it is only fitting that it be assigned a relatively lower hurdle rate as compared to the store cash flows which forms a bigger part of the company’s income.

 

On the other hand, to see if the estimated discount rates are reasonable, many companies use their weighted average cost of capital (WACC) if the project’s risk profile is similar to that of the company. Simply computed as:

 

WACC = E/V*Re + D/V*Rd*(1-Tc)

 

Where:           Re = cost of equity

Rd = cost of debt

E = market value of the firm’s equity

D = market value of the firm’s debt

V = E + D

E/V = percentage of financing that is equity

D/V = percentage of financing that is debt

Tc = corporate tax rate

In hindsight, if the firms accept projects that are equally risky as the firm, then firm risk will substantially not increase and the firm’s cost of capital remains unchanged as well. In this case, using cost of capital as the discount rate is more appropriate. In effect, using weighted average cost of capital serves to gauge if the discount rate is indeed reasonable and should definitely be higher than the former as the firm takes more risks.

 

Alternatively, the Capital Asset Pricing Model (CAPM) can also be used to calculate the discount rate and inherently reflect if the assumed or predicted hurdle rate is within reason. This is a plausible process if the project’s risk profile is substantially different from that of the company since it more accurately reflects its risk. Similarly, it measures the cost of capital (R) or the minimum rate of retum equity investors require for providing capital to the firm. According to the model, it is comprised of the risk free rate of interest (Rf) and a premium for the firm’s risk (Rprem) as shown in the equation, R = Rf + Rprem.

 

IRR would also be a possible choice in estimating the discount rates. IRR can be used to rank prospective projects, and the one with the highest rate of return is considered by firms to be the best and be tested out first. Formula is written as:

 

0 = P0 + P1/(1+IRR) + P2/(1+IRR)2 + P3/(1+IRR)3 + . . . +Pn/(1+IRR)n

 

Where                        P0 to Pn = cash flows in periods in 1 to n

IRR = the project’s Internal Rate of Return

 

If all NPVs show positive values and the IRRs are not desirable, the NPV may supplant the IRR in making the decision. Goldie’s Square show the least IRR among the five CPRs, and can be funded through debt if it will be allowed by the CEC. (see #4)

 

 

 

 

 

 

 

 

 

 

 

 

4. As a member of the CEC, would you continue to approve CPRs if it meant that Target would need to fund the requests with external funds, either debt or equity?

            Yes, because the CPRs will have a great impact on both the short-term and long-term profitability of Target. It doesn’t matter even if the CPRs require using external funds because as long as the CEC makes the right decision on which CPRs to accept, these projects will contribute to the growth of the company as well as create value for its shareholders. It is also good to spend external funds so that the budget allocated for the firm’s regular operations will not be deducted.

 

Based on our previous answers, there are many factors to consider and not only the NPVs and IRRs of each CPR. We accepted the Whalen Court CPR despite the high investment required because we considered the demographics of the area, which has the highest population as well as the highest number of adults with college education. On the other hand, we did not accept the Goldie’s Square CPR despite a positive NPV and IRR because it has the highest number of competitors in that area and requires the largest amo