Assignment: Capital Budgeting
Today is Dec 31, 2022. THP is a clothing retailer that started its business 20 years ago. It currently has two locations within Scarborough Town Centre shopping mall, one near Entrance A (Location #1) on the upper floor and one near Entrance F (Location #2) on the lower floor. The 2022 income statement for each location and other selected information are shown below (For the purpose of this assignment, consider 2022 as Year 0, 2023 as Year 1 etc.).
Due to the recent COVID pandemic and its impact on THP business, THP is currently assessing different options that may be available to them. Possible options include:
• Close down either one of the stores or both of its stores
• Consolidate the two stores into one store by moving to a different location near Entrance C within the same mall
Both Location #1 and Location #2 still have 7 years left in its current lease term (i.e., leases expire in Dec 31, 2029). If THP decide to terminate the leases today by closing the stores, they would have to pay the landlord a lease termination penalty of $75,000 for Location #1 and $150,000 for Location #2. If they stay in their current location, it is expected that Location #1 and Location #2 will experience a sales growth of 5% per year and 3% per year respectively for the next 7 years. Based on the current lease agreements, the rent for Location #1 and Location #2 will increase at a rate of 2% and 4% per year respectively. COGS, Salaries and G&A expense is expected to remain the same as a % of sales at the level seen in the 2022 income statement. It is also expected that both locations will maintain the same inventory turnover ratio each year for the next 7 years as those in 2022. THP has been taking a very aggressive tax depreciation (CCA) strategy on leasehold improvements and equipment for both locations. As a result, the UCC balance as at Dec 31, 2022 is zero despite still having 7 years remaining in the lease. When THP close a store at any time, it is expected that they can sell off their inventories to another retailer at 30% of the book value.
THP could try to negotiate with the landlord and consolidate the two stores into one at a different location. The new store location near Entrance C would be larger in size at 28,000 square feet. The lease term for the new location will be for 7 years as well (i.e., expire in Dec 31, 2029). The sales for the new store location for the next 7 years is expected to be 85% of the projected combined sales of Location #1 and Location #2 if they were continue to operate (for example, Year 3 sales of new store location is equal to 85% of the projected Year 3 sales of Location #1 and Location #2 combined. Also assume you can open this new location on Jan 1, 2023 so Year 1 sales will be a full year worth of sales). Since the new location is more similar in size to Location #1, its operating metrics (COGS as a % of sales, Salaries as a % of sales, G&A as a % of sales and inventory turnover ratio) are expected to be the same as those in Location #1. The rent expense for the new store location is $8.50 per square feet per year and is expected to remain the same for the duration of the lease term. If THP decide to consolidate the two stores into one, it would not have to pay the lease termination penalty for Location #1 and Location #2 mentioned above despite "breaking" the lease and will no longer operate out of those two locations.
The total construction/renovation cost of the new store location is $20 per square feet. 65% of the total construction cost belongs to Leasehold Improvement and 5% CCA class, the other 35% of the total construction cost belongs to Furniture, Fixtures and Equipment and 30% CCA class. At the end of the lease, the leasehold improvement is not expected to have any salvage value but the Furniture, Fixtures and Equipment can be sold off for $90,000. The inventories from Location #1 and Location #2 can be directly transferred to the new store location under this scenario and continue selling starting Jan 1.
The tax rate for THP is 35% and the cost of borrowing for THP is 8%.
Based on the information above, what is the best decision for THP as of today? Rank each of the options available to THP from best to worst and support your answer with detail financial analysis on each of the scenarios. Discuss what options are available to THP at this time and why you are recommending your particular option.