Wal-Mart Case 19: Target

This case provides insight into how capital budgeting decisions are made and the factors that influence the decision making process of large corporations. Specifically, the case centers on the capital expenditure meeting for the Target Corporation, which is one of the top ten retailers in the United States. All corporations have some version of this meeting. The goal of the meeting is to determine what capital expenditure projects the company will undertake in the future to promote growth. Below is our analysis of the Target Corporation’s top five capital budgeting requests (CPR) up for debate. We will first compare Target’s business model with its two top competitors, Wal-Mart and Costco, then we will analyze Target’s capital budgeting process, explain the importance of dashboards to managers, explain how we decided which CPRs to accept, discuss the different hurdle rates Target uses and discuss whether financing CPRs through debt or equity is a good decision for Target in the future.

Business Model Comparison

Target’s main competitors are Wal-Mart and Costco. While other retail stores such as Sears, JCPenney and Meijer’s create competition, Wal-Mart and Costco have similarities with Target’s business strategy and thus investment analyst tend to compare these three firms regularly. Target’s mission is “to make Target your preferred shopping destination in all channels by delivering outstanding value, continuous innovation and exceptional guest experiences by consistently fulfilling our  The store’s business model centers on appealing to style-conscious consumers by offering unique assortments of home and apparel items, while competitively pricing on items unique to both Wal-Mart and Target. They also call all customers guests to make the shopping experience more comfortable.

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Target prefers not to fund any CPRs through debt or equity. Due to massive advertising campaigns the round bulls-eye logo is one of the most recognized logos in the United States (U.S.). Target’s business model focuses on its’ core customer base of college-educated women, with children at home who are more affluent than typical Wal-Mart customers. Wal-Mart’s business model is somewhat similar, but centers on “saving people money so they can live better” at “every-day low prices”. They also call all employees associates, which is designed to increase employee morale and create a more professional shopping experience.

Wal-Mart stores are set up similar to Target, operate in the same trade areas and have similar merchandise. Even though Wal-Mart’s earnings surpass all other retailers by a substantial amount they are still one of Target’s top competitors. The differences lie in Wal-Mart’s focus on “everyday low prices” and Target’s focus on appealing to style-conscious consumers while also pricing competitively. While Wal-Mart’s business strategy has proven to earn more, Target’s strategy has proven to be very successful as well. Costco on the other hand has gone a different route with its business strategy, but attracts the same type of consumers Target does.

Costco is “a membership warehouse club, dedicated to bringing [their] members the best possible prices on quality brand-name merchandise. Costco provides a wide selection of merchandise, plus the convenience of specialty departments and exclusive member services, all designed to make your shopping experience a pleasurable one”. The main difference in their business strategy compared to Target’s is the membership-fee format, which requires customers to pay a fee for membership, which in turn allows them access to discounted retail items. Both Target and Costco’s business strategies overlap in the area of delivering a pleasurable shopping experience along with low prices, and have led to similar financial earnings. While Costco, Wal-Mart and Target have overlapping business strategies major differences exist which set each company apart and help them to stay competitive in the ever-changing retail industry.

Target’s Capital Budgeting Process

Capital budgeting is the process of evaluating and selecting long-term investment. For target, this process is meant to be rigorous because capital investment has significant impact on the short-term and long-term profitability of the company.

Targets Capital Budgeting process includes:

1. Proposals are prepared. CPRs (Capital Project Requests) go through a 12-24 months of development prior to being forwarded to the CEC for consideration. These proposals vary widely from remodeling, relocating, rebuilding, and closing existing stores.
2. Projects are then partitioned because not all projects that are proposed as investment opportunities can actually be profitable. It’s at this point that the CEC (Capital Expenditure Committee) reviews the proposed CPRs.
3. Projects in excess of $100,000 are evaluated by the CEC; however projects larger than $50 million, require approval through the board of directors.
4. Also in situations where the CEC cannot agree, the CEO will make the final decision. Management’s highest priority in their decision-making process was to continue its growth by opening approximately 100 stores per year in the United States and maintain a positive brand image. Their strategy to maintain growth was not necessarily to focus on low prices such as Wal-Mart; however, their strategy was to consider the customer’s shopping experience as a whole.

This is definitely in line with the company’s business and financial objectives because according to the article, projects also needed to meet a variety of financial objectives, starting with providing a suitable financial return. The measurement of this is NPV, IRR, projected profit, and earning per share impacts, total investment size, impact on sales of other nearby Target stores, and the sensitivity of NPV and IRR to sales variations. Therefore, when the CEC needed to make investment decisions, the financial objectives are the driving force in order to meet the 100 store per year goal as well as maintaining brand image.

There are both negative and positive aspects to Target’s capital-budgeting system. To begin, the main goal of Target’s management is to open approximately 100 stores every year; therefore, in the case of these new store proposals, a real estate manager assigned to that geographic region was responsible for the proposal from beginning to end as well as reviewing and presenting the proposal details. This is a logical approach because the real estate manager has a better understanding of the region in which a store would be open. For example, is the area very brand conscious or not? Does the region get a lot of foot traffic? Is the region growing rapidly and therefore, the area is a good candidate for a Super Target? This process would be similar to having a subject matter expert. The real estate manger should have a good understanding of what type of store would fit best in which region. However, as the article noted, there are expenditures that cannot be recovered if a project is rejected as well emotional sunk costs. According the finance theory, it says to accept all positive NPV projects.

Therefore, the CEC is in place to essentially eliminate projects even though they have a positive NPV. Two problems including an increasing marginal cost of capital and capital rationing occurs when not all positive NPVs are accepted. A higher cost of capital would appear to investors as risky and capital rationing places restrictions on the amount of new investments or projects. Although the restrictions on investments could be considered a negative aspect, it does have some possible positive results. For example, capital rationing is important in situations where if Target were to approve projects in excess of the budgeted amount, they would need to borrow money to fund the shortfall. Adding debt also increases the risks to shareholder. Nonetheless, not accepting all proposed projects with positive NPVs limits market capitalization and brad visibility.

It also appears that a significant amount of investment decisions are made by executive officers rather than the board of directors. This can lead to a variety of behaviors that could harm the firm. The CEC could avoid some difficult decision such as closing a store out of loyalty to others in the company. Also, the CEC could choose to reject risky positive NPV project to avoid looking bad if a project fails or the CEC could make the decision to pay too much in acquisitions. However, all of the CEC members have been with Target for a significant period of time. Each has a significant amount of experience that can aid in the decisions to either invest or not invest in a particular project. Sometimes, despite the numbers, experience is an intangible asset.

Importance of Dashboards

As a Target manager, the CPR dashboards are essential for understanding the risks and rewards each proposed request brings to the company. Each piece of information has been chosen to be part of the dashboard for a specific reason. The dashboards are separated into the following 8 sections plus graphs:

1. Financial Summary
2. Store Sensitivities
3. P&L Summary
4. Investment Detail
5. Building Cost vs. Prototype
6. Incentive Summary
7. Demographics
8. Comments

The Financial Summary section is included so managers can see how the proposed project compares with the prototype project. The following subsections are included:

1. Total R&P Sales
2. Incremental R&P Sales
3. Investment
4. Value

For example under the subsection Total R&P Sales, the 1st year 2006 equivalent for the project could be $27,000, if the B/(P) Proto column shows a negative amount this means the project’s 1st year 2006 equivalent is that much less than the prototype. If the number is positive the project is expected to earn more sales than the prototype. This section lets managers quickly see the projected sales, the amount of investment required and the overall value compared with the prototype.

The Store Sensitivities section is included to provide an overview of the project’s possible hurdle adjustment, risks/opportunities and variance to prototype. The hurdle adjustment shows managers how sales, gross margin and construction costs could impact the Net Present Value (NPV) and Internal Rate of Return (IRR) values with respect to the prototype amounts. The Risk/Opportunity section shows managers the impact of a possible decrease in gross margins, increases in construction costs, market fluctuation impacts (changing market margins, wage rates, etc.) and a 10% increase or decrease in sales.

Depending upon the level of risk associated with the project and the likely hood of these risks coming to fruition, managers could decide the risks are too high even if a project has a positive NPV. The P&L Summary explains the impact on earnings before interest and taxes (EBIT). The Investment Detail section is included because it shows specific investment details for the CPR and allows managers to compare these with other current and past CPRs to see if the investment is in line with them. For example, the PSF line item allows managers to see the cost impacts of different project locations. The next section, Building Costs versus Prototype Costs, is included to provide managers with a quick comparison of the projects expected construction costs compared to the prototype costs. In some cases managers may question why building costs are different from past projects and ask for an explanation even though the NPV value is positive. This section helps managers to avoid setting a new precedence for the amount of building costs allowed. The third to last section, Incentive Summary, gives managers insight into additional fees the project may include. The last two sections provide basic demographic details and any additional comments the project leads may want managers to know.

The demographic details help managers to align the location of projects with the overall corporate vision and business strategy for the future. They also help managers see whether future growth, for example a Target supercenter, is possible. The comments section allows the project lead to included data not specifically addressed in other sections of the dashboard because each project is unique and has its own set of risk and rewards. This comment section is very important as it can provide additional details to mangers that could change their initial decision on the project. For example, a project with a negative NPV could be accepted if the opportunities and rewards explained in the comments section outweigh the quantitative data presented. Lastly, four graphs are included so that managers can quickly see comparisons without having to delve into the specific data; the first is a graphical representation of NPV & Investment of the project versus the prototype and the second is project sales versus prototype sales. The third and fourth graphs show how Target stores compare percentage wise with Wal-Mart stores, both regular and supercenters, in a particular area. This aids mangers by helping them decide what type of store would be best suited to compete against Wal-Mart.

The main quantitative figure managers rely on is the NPV. IRR is also included on the dashboard, but can conflict with the NPV results. IRR is included because it forces managers to weigh all aspects of the project and not simply rely on what the NPV value says. While NPV is the most widely used figure for making investment decisions we think other tools should at least be considered. While NPV takes into account all future cash flows, the time value of money (TVM), the riskiness of cash flows and is an objective benchmark, there are negatives associated with it. Some of the negatives include fluctuations in the weighted average cost of capital (WACC), it ignores liquidity risks, ignores unequal project lives and ignores profit margin. In Target’s case most of the CPRs are for new stores, which most likely have slight fluctuations in project life. While managers see the numbers in comparison to a prototype we believe adding an Equivalent Annual Annuity (EAA) figure and Profitability Index (PI) would be beneficial.

EAA is similar to NPV, but takes into account unequal project lives and partial liquidity risks. It’s reasonable to assume each proposed project’s life would never match exactly and thus having this EAA figure would allow for a better comparison of each project. PI compares profits to costs and while not necessarily a figure to solely base decisions on it would provide managers with a quick look at how profits of a project compare with their costs. If profits do not surpass costs substantially this could signal problems in the future. Other tools such as payback, discounted payback and modified IRR should be computed, but only at lower levels of management. Management should be prepared to provide these figures if for some reason corporate management asks for them during their evaluation.

Analysis of CPR’s

NPV and IRR

Both the NPV and IRR are strong for Gopher Place. The NPV is positive and above the prototype numbers. The IRR for the store is at 12.7% which is above the 9% used to calculate NPV for the store. Also the IRR for credit is 8.1% which is above the 4% used to calculate the NPV for credit. For Whalen Court, IRR is strong with both store and credit IRR over the cost used to determine NPV. NPV is less that the prototype NPV by about 3k in the store but greater by about 7k in credit. However NPV and IRR are both low in terms of investment. Because this project is such a unique one, it’s hard to use the prototype as an accurate benchmark. For Goldie’s Square, NPV is weak compared to the prototype store’s NPV below almost $20,000 and IRR for the store is also weak at 8.1%. Although the NPV and IRR’s are weak this may still be a good investment when considering competition and brand awareness. NPV is positive and IRR is also above the rates used to calculate NPV for the Stadium Remodel.

Size of the project

Gopher Place would be a P04 store around 127,000 square feet. There would be an initial investment of $23.0 million which is higher than the prototype numbers. Whalen place is a large project with a 170,000 square foot store requiring $119.0 million in investment. The store would be a unique single story store in a major urban area. The Barn would also be a P04 store around 126,000 square feet requiring a $13.0 million investment. This store would be a superstore at 170,000 square feet and an investment of $24.0 million. Goldie’s Square would be a SuperTarget at 170,000 square feet and an investment of $24.0 million. Stadium Remodel would be a $17.0 million investment to remodel the interior of a SuperTarget.

Cannibalization of other stores’ sales

Gopher Place would have a high cannibalism rate because currently there are five other Target stores in the Gopherville vicinity. It is estimated that 19% of the new store’s sales would come from other Target stores. There are currently 45 other stores in the Whalen Court market however there are none like this potential store in the center of the large metropolitan area. It is not estimated that other stores would lose any sales because of the new store.

There would be no cannibalization with The Barn as the closet Target store is 80 miles away. There would be some cannibalization of other stores with Goldie’s Square. Currently there are 12 other stores in the market with a plan to have 24 in the future. There would be transfer sales of three nearby stores. With the Stadium Remodel, there would be no cannibalization of other store since this is just an interior remodel.

Store sensitivities

Gopher Place’s sensitivity analysis for the hurdle adjustment is relatively strong. Sales could decrease by 5.3%, gross margin could decrease by 0.72, and construction costs could increase by 5k and still reach the prototypes NPV. Also the risk/opportunities section is strong compared to the other CPR with an 10% decrease of sales lowering NPV by 4k and 1 pp GM decline lowering NPV by 3k. Both of these are relativity low compared to the other CPRs. For Whalen Court, both the hurdle adjustment and risk/opportunity sensitivity analysis are both weak when compared to the prototype. As stated before since this is such a unique project it’s hard to have an accurate benchmark to compare to. Also the potential marketing benefit could outweigh any initial loss. BARN. All areas of the hurdle adjustment for Goldie’s Court would need to be stronger in order to reach the NPV of the prototype. Looking at the market specific conditions NPV would increase by $6,000. The risk/opportunities seem reasonable for the Stadium Remodel. There are no benchmarks to compare with making it difficult to make an accurate judgment.

Variance to prototype

All areas are strong with the variance to the prototype except for the non-land investment which brings a 4.7k negative variance for Gopher Place. For Whalen Court, the only store variance to prototype is sales which bring a positive variance of almost $100,000. BARN. The only strong indicator for Goldie’s Court would be the land investment being a positive $1,500 to the prototype. Not applicable for the Stadium Remodel.

Customer demographics

Currently there is a small population for the amount of stores in the Gopher Place area at only 70k but there is expected to be a 27% increase over the next five years. Also the median income is higher than the other areas in which a CPR is being considered. A higher income population is more likely to shop at Target than at Wal-Mart, as Target markets to these types of consumers. For Whalen Court, the strong points are the customer demographics is the large population size and large percentage of college educated consumers. The Barn’s customer base has a lower income with a small population growth projected for the next five years. There are strong customer demographics with a large population and an estimated population growth of 16% over the next five years for Goldie’s Court. Also about a fourth of the population has a college education. There is a high median income and a large percentage of consumers hold a college degree in the Stadium Remodel area.

Brand-awareness impact

The consumers in the Gopherville area are already aware of the Target Brand with five other stores in the area. The potential brand awareness is the strongest attribute for the Whalen Court project. Being located in a large urban area provides advertising to any passersby.

The Barn would be a new store entering a new market. Increasing brand awareness is one of the strongest components of the Goldie’s Court project. The store would be going in a new area where many competitors will also be. A remodel would certainly help the brand awareness in the Stadium Remodel area but more importantly no remodel would serious damage the brand in the affluent family-oriented area. After analyzing the different aspects of the dashboard for each CPR, we can come to the conclusion that each CPR has its pros and cons.

Looking at each CPR individual, they each provide value to the company. If possible all CPR’s should be should be accepted but this may not be realistic. So in order to choose which CPR should be accepted comes down to which pros are more important and which cons can be accepted for Target. For example, since Target’s stock price has been declining the company may want to consider which projects will bring them short term financial goals in order to capitalize on their main goal: maximize profits for the shareholders. So looking at some financial indicators such as NPV Whalen Court, and The Barn provide the biggest NPV and the smallest negative impact on the first years EBIT. If the company was more focused on providing more long term growth, they would want to invest in the CPR’s that would improve their brand image such as the Stadium Remodel and Glodie’s Square. It’s difficult to determine which CPR’s should be accepted without knowing the specific short and long term objectives and goals for the company.

Hurdle Rates

There are several reasons why Target would use different hurdle rates when considering multiple capital expenditure requests across a multitude of different project types. In this case, Target uses a hurdle rate of 9% for stores and 4% for credit cards. This number represents the baseline minimum that Target expects a new store project to have an IRR of greater than 9%, and for credit cards, the IRR needs to be greater than 4%. One of the reasons is that stores represent a far greater economic investment in order to pursue the project and expand the company by creating a new one. In order to have a functioning store land needs to be bought, a building needs to be constructed and inventory needs to be purchased for store shelves along with all the human resources that will need to be hired to manage and run the daily operations of the facility. All of these things represent continual fixed costs that are to be incurred by Target in the long term after opening the store.

The higher hurdle rate helps to give the company a more conservative estimate of what future WACC rates the company might incur. The credit cards would likely have a substantially smaller hurdle rate as they do not require substantial investments in operating capital, nor do they operate on a razor thin margin. The case mentioned that 14.9% of operating earnings came from the credit card division, making the division highly profitable. Even if the WACC for target was to increase 1-2%, the credit cards would still be a very profitable venture, while for a given store it could easily be make or break in regards to its profitability.

CPR’s with External Funding

As a member of the CEC, I would analyze what the cost of capital would be both considering both debt and equity in order to determine if any given project should be granted approval. Just because outside funding needs to be secured does not automatically mean that further capital projects need to all be rejected. External funding for projects is a great use of a company’s financial leverage in order to further advance the strategic objectives of the firm. It was explained within the case multiple times that the corporate strategy of Target is to expand operations, increase sales revenue, and enhance the brand image of the company.

It is important for the company to pursue expenditures which help to support these goals. Although additional debt or equity might have to be incurred to finance these projects, the cost of the additional capital should be used to adjust the standard calculations to ensure that the proper rates are used when calculating NPV, EAA etc. If the WACC for Target goes from 10% to 11% due to an added debt or equity load on the company, that could have a drastic effect as to if any given project would be accepted; especially if said project only has an IRR of 10.75%, for example.

Even though that initial example project might be rejected, there could very well be other projects that have an IRR of 11.5% or 12% that would still be very acceptable even with the higher WACC that Target would be incurring. Another thing to consider would be the WACC effect on CURRENT projects and operations of the firm. If the WACC goes from 10% to 11%, current outstanding projects and facilities could quickly go from being profitable to non-profitable, depending on how steep the NPV profile is for any given project. Lastly, it was stated within the case that there are financial statement considerations in regards to taking on additional debt to fund a new project.

If the funding requirements for the project are substantial, it can have a material effect on the income statements of the firm. Any substantial changes to the financial statements of the firm can have a large impact on the stock price, and as an executive in the company, the compensation I receive would likely be directly tied into stock performance, so I would personally have an incentive to not do anything that might have a strong adverse effect on the company’s shareholder return.

References

1. Mission and Values. Target Brands, Inc., 2013. Web. 29 June 2013.
2. Why Become a Member. Costco Wholesale Corporation, 2013. Web. 29 June 2013.

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