Joan Chris is the Denver district manager of Stale-Mart, an old established chain of more than 100 department stores. Her district contains eight stores in the Denver metropolitan area. One of her stores, the Broadway store, is over 30 years old. Chris began working at the Broadway store as an assistant buyer when the store first opened, and she has fond memories of the store. The Broadway store remains profitable, in part because it is mostly fully depreciated, even though it is small, is in a location that is not seeing rising property values, and has had falling sales volume.
Stale-Mart owns neither the land nor the buildings that house its stores but rather leases them from developers. Lease payments are included in “operating income before depreciation.” Each store requires substantial leasehold improvements for interior decoration, display cases, and equipment. These expenditures are capitalized and depreciated as fixed assets by Stale-Mart. Leasehold improvements are depreciated using accelerated methods with estimated lives substantially shorter than the economic life of the store.
All eight stores report to Chris, and, like all Stale-Mart district managers, 50 percent of her compensation is a bonus based on the average return on investment of the eight stores (total profits from the eight stores divided by the total eight-store investment). Investment in each store is the sum of inventories, receivables, and leasehold improvements, net of accumulated depreciation.
She is considering a proposal to open a store in the new upscale Horse Falls Mall three miles from the Broadway store. If the Horse Falls proposal is accepted, the Broadway store will be closed. Here are data for the two stores (in millions of dollars):
| Broadway (Actual) | Horse Falls (Forecast) | |
| Average inventories and receivables during the year Leasehold improvements, net of accumulated | $2.100 | $2.900 |
| depreciation | 0.900 | 4.600 |
| Operating income before depreciation | 1.050 | 3.300 |
| Depreciation of leasehold improvements | 0.210 | 1.425 |
Assume that the forecasts for Horse Falls are accurate. Also assume that the Broadway store data are likely to persist for the next four years with little variation.
Stale-Mart finds itself losing market share to newer chains that have opened stores in growth areas of the cities in which they operate. The rate of return on Stale-Mart stock lags that of other firms in the retail department store industry. Its cost of capital is 20 percent.
Required:
a. Calculate the return on total investment and residual income for the Broadway and Horse Falls stores.
b. Chris expects to retire in five years. Do you expect her to accept the proposal to open the Horse Falls store and close the Broadway store? Explain why.
c. Offer a plausible hypothesis supported by facts in the problem that explains why Stale- Mart is losing market share and also explains the poor relative performance of its stock price. What changes at Stale-Mart would you suggest to correct the problem?
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