THE CATALOG COMPANY (C)
The Catalog Company is a small, family-owned mail-order business established in 1946. While the company has consistently earned a profit over the past 38 years, fiscal 1984 (ended 12/31/84) was its best year ever (Exhibit 1). Sales reached a record $3 million with net profit of $70,000.
The company operates out of a small building (65,000 square feet) which houses offices, warehousing facilities and a factory store. Given the company’s recent rapid sales expansion, the building is crowded and disorganized. The facility was built in 1946 and the warehousing system is not organized for high volume. While the accounting system is computerized, the inventory control procedures are not very sophisticated. Management does not track inventory turnover and profitability by stock-keeping units (SKU’s). Instead, data is aggregated by four major product groups:
% of Sales
Camping equipment 12
Sporting goods 8
Eighty percent of sales are by mail-order; twenty percent are through the factory store. The company generates mail-order sales by distributing catalogs to a select list of current and prospective customers. Currently, there are 600,000 names on the mailing list. Four catalogs are distributed each year.
Although the catalog industry is highly competitive, the outlook is excellent for well-managed firms. The industry faces growing demand (15 % annually), as well as the potential for both rapid asset turnover and high profit margins. Net profit margins can be as high as 7 to 8 percent.
The Catalog Company has a reputation for distributing quality merchandise and standing behind its products. In addition, the company has 38 years of catalog merchandising experience and considerable expertise in designing effective catalogs.
Ó Pete Nye, 1996
CEO Jack Newton believes that the company is well positioned to grow faster than the industry, but their current warehousing operation cannot support much more volume. With larger, more modern facilities, the company could control its own growth rate over the next eight to ten years simply by regulating the number of catalogs they distribute.
PROPOSAL FOR EXPANSION
Newton has approved a plan to capitalize on the increasing demand for quality mail-order service. The plan calls for: 1) doubling the warehouse space, and 2) instituting a “state of the art” inventory control system which would require a substantial investment in computer hardware and software.
Warehouse space could be doubled almost immediately (January-February, 1985). Alternatively, initial cash requirements could be reduced by phasing in the expansion over several years. Four options have been suggested:
Plan 1: Warehouse space could be doubled almost immediately (January-February, 1985) at a cost of $1,100,000. This quick expansion would support 15 percent sales growth in 1985. Beginning in 1986, the company could accommodate an annual growth rate of approximately 20 percent (16% to 22%).
Plan 2: The warehouse could be expanded in two stages, requiring capital spending of $600,000 at the beginning of 1985 and an additional $600,000 in 1986. Under this plan, sales would grow at only 12 percent in 1985, but once the project is underway (1986), the company could accommodate an annual growth rate of approximately 20 percent (16% to 22%).
Plan 3: Warehouse expansion could be delayed entirely until 1986. This would allow one year to begin implementation of the new inventory control system before dramatically expanding inventory and sales volume. This two-stage expansion plan would require investment of $600,000 at the beginning of 1986 and an additional $600,000 in 1987. Under this plan, the company could not support sales growth of more than 12 percent until mid-1986. After that time the company could accommodate annual growth of approximately 20 percent (16% to 22%).
Plan 4: The warehouse could be expanded progressively over three years at a total cost of $1,200,000. However, rapid sales growth would be constrained by the availability of warehouse space. The company could not support sales growth of more than 12 percent until the second year of a three-year expansion plan.
The inventory control system could be implemented in one year or phased in over two years. However, this project must precede or coincide with warehouse expansion. The total cost of this project will be $800,000, regardless of timing.
Since the family wants to maintain strict control of the company, they are reluctant to issue new common stock.
Instead, they have agreed that they will forego dividends for the next four or five years. However, this ambitious expansion plan will clearly require some external financing as well. They hope to fund expansion by:
1) retaining all earnings in the business, and
2) borrowing from the bank (long-term debt) to cover any additional funds requirements.
After initial discussions, the bank has indicated a willingness to support a “prudent” expansion plan with long-term financing (as needed) over the next five years. The bank would charge a rate tied to both the prime rate and the company’s degree of financial leverage:
LTD/(LTD + Equity) rate
=< .30 .10
>.30 but =<.40 .11
>.40 but =<.45 .13
>.45 but =<.55 .16
If the expansion plan imposes undue financial strain on the company, the family might consider issuing new stock in an amount not to exceed $500,000.
Newton is determined to implement the project, which promises to be extremely profitable in the long-run. His current challenge is to develop a workable financing plan.
In order to forecast financing requirements, Newton’s management team has built a computer model. The model allows management to test the impact of alternative capital spending plans on the firms financing needs, performance and financial condition.
ASSUMPTIONS. The following assumptions have been “built into” the model:
1. Cost of goods. While the cost of goods will be about 62% of sales in 1985, improved inventory control and efficiencies in purchasing could bring that cost down to 60 percent beginning in 1986.
2. Operating expenses. Operating expenses will be 32 percent of sales in 1985. Thereafter, the modernized warehouse could reduce operating expenses to 30 or 31 percent.
3. Depreciation. The warehouse expansion is classified as a 15-year asset under the Accelerated Cost Recovery System. Investment in the inventory control system can be depreciated on a 5-year basis. The firm’s average tax rate is 35%.
POLICY VARIABLES. The model assumes that management exercises substantial control over four policy variables (Exhibit 2): the amount and timing of capital investment, the rate of sales growth, the rapidity of inventory turnover, and the issue of new common stock.
Sales growth. Management maintains considerable control over sales growth. Management can generate new orders simply by sending out more catalogs to its target markets. However, the company’s ability to efficiently fill new orders is constrained by the availability of warehouse space and “state of the art” inventory control methods.
The complete expansion plan (once implemented) will support sales growth of approximately 20 percent (16% - 22%). This high growth rate could be sustained for at least 4 or 5 years. However, rapid growth will require more intense marketing effort ($$)as well as increased levels of working capital. Both of these requirements have been built into the computer model.
Inventory turnover. Management has some control over the inventory turnover rate. Inventory turnover can be increased by a combination of more intensive marketing and implementation of the efficient inventory control system. Current inventory turnover is slow. With the new system the company should be able to turnover inventory at least 7 times a year and possibly as many as 10 times.
OUTCOME VARIABLES. The model summarizes the financial impact of an expansion plan both numerically (Exhibit 2) and graphically (Exhibits 3A & 3B).
Newton must decide how much money to borrow for expansion. Since the bank is willing to negotiate a “line of credit," he can adjust the level of debt from year to year. However, he is concerned that financing requirements in the early years may impose unhealthy levels of debt. Newton is also concerned about possible cashflow problems.
1. Propose a specific expansion plan. Clearly identify planned growth rates and financing requirements (How much must the company borrow each year to support your plan?).
2. Defend your proposal. Consider its impact on the firm’s financial structure, debt-servicing ability and profitability.
The computer model can help you in evaluating alternative expansion plans.
Financial Impact of Capital Spending Plan:
Financial Impact of Capital Spending Plan: