1. AMCE, Inc. is considering adding a loyalty program in which its customers can earn points for discounts in lieu of running storewide promotions. Additionally, ACME would collect information on its customers' shopping transactions, which allow ACME to craft individualized promotions.
Currently ACME has $225 million in annual sales generating a profit margin of 3.0 percent on sales and an asset turnover of 4.5. ACME's marketing group believes the loyalty program would increase sales by $20 million with an additional investment in working capital of $2.5 million to support the increased sales. Costs to run the loyalty program would reduce profit margin to 2.8 percent.
Based solely on the above financial consideration, explain whether you would recommend management consider adding this new program.
2. Calculate the cost of capital for operations (WACC). Use the capital asset pricing model to estimate the cost of equity capital.
U.S. Government long-term bond rate 2.7%
Market risk premium 4.0%
Equity beta 0.80
Per-share market price $55.00
Shares outstanding 20 million
Net financial obligations on balance sheet $1,000 million
Weighted-average borrowing cost 6.0%
Statutory tax rate 35.0%
3. Given your analysis in 2 above, explain why the cost of equity capital, ρE, is actually based on the cost of capital for the firm, ρF.
4. What is the principle assumption that allows an analyst to modify a residual earnings (RE) model to a residual operating earnings (ReOI) model? Explain.