Murphy Stores

Capital Projects
 Outline
• Investment opportunities
• WACC calculation & comparison
• Evaluation & analysis of EAS and Lighting Replacement
projects
• Key value drivers and major risks/uncertainties
• Scenario analysis for both projects: best & worst case
• Recommendations
 Investment Opportunities
Tom Becker (Manager of Capital Planning for Murphy Stores) is evaluating how to
allocate $7M of the remaining budget into two cost-savings projects:
• The first project is implementing Electronic Article Surveillance (EAS)
technology, which would reduce merchandise theft from stores. This option
has numerous financial benefits: increase in differential sales, reduction in
cost of goods sold, and higher gross margin dollars
• The second option is to invest in a new energy-efficient store lighting,
which would decrease energy demand by 30% to 40%, increase visibility and
light, and minimize the use of air conditioner. Also, this lighting conversion is
environmentally friendly, which supports the company’s sustainability
objectives
 WACC Calculation
Using the CAPM model

WACCCalculation
Tax rate 39%

Capital structure 100% 100% 100%

Debt 20% 20% 20% • As most Murphy’s investments are matched by
Equity 80% 80% 80% the lifetime of medium term Treasury notes and spreads,
we use medium term T-notes (4.5%) as a proxy for
Worst Case Base Case Best Case the risk free rate, and Rm-Rf (7%) as the risk market
premium
Cost of Equity 15,40% 12,90% 11,65%
Risk free 5,0% 4,5% 4,5% • The company uses investment grade bond yields to
Beta 1,3 1,2 1,1 determine the cost of debt, and Grade A corporate bonds
Risk market premium 8,00% 7,00% 6,50% have a rate of 6.75%

Cost of Debt 7,25% 6,75% 6,75%

Corporate bonds (A) 7,25% 6,75% 6,75%

WACC 13,20% 11,14% 10,14%

 Calculated WACC vs. 12%
Assumption
• WACC, as Murphy Stores assumes, is 12%, which is 0.86% more than the
calculated WACC
• The discount rate of 12% used by the company will underestimate the future
potential of projects
• This would result in a lower NPV, and lower NPV can transform profitable
projects into projects that are unsuccessful
• Therefore, using a high discount rate implies that Murphy wanted to be more
conservative and that the capital committee felt that project proposals are
optimistically biased: “Nobody submits a project he doesn’t like”
 Evaluation of EAS Project
• Benefits of reducing shrink:
• Higher sales: opportunity cost of lost sales due to stolen merchandise
• Lower COGS: cost savings from not having to replenish the merchandise
• Higher gross margin dollars: differential gross margin
• We evaluated the project based on these 3 approaches for the full-line stores
and for the hardware stores
 EAS Full-Line Project Inputs
Inputs in K$
• WACC used is the one we calculated earlier
Sales (23 Full-Line Stores) 500 000,00 Assumptions in Q2
Sales Growth % 6,00% Outputs
• Shrinkage decline used is 35% as the studies
Cost of Goods Sold % 55,30%
Gross Margin 44,70%
shown a fell in shrinkage between 20% and
Cost of Capital (WACC) 13,20% 50% and Murphy’s managers would not want
Shrinkage 3,60% to be too optimistic
Shrinkage Decline 35,00%
Inflation 4,00% • Our assumption behind the annual growth
Tax Rate 39,00% rate of shrink is our average shrink without
Annual Growth in Shrinkage Rate without EAS 0,22% EAS in 2007 multiply by the expected annual
Investment (Capex) 3 036,00 sales growth
Cost of Goods (Tags) 1 564,00

Depreciation table

1 2 3 4 5 6 7 8
MACRS table 14,29% 24,49% 17,49% 12,49% 8,93% 8,92% 8,93% 4,46%
Depreciation of cost of capital/store 433,84 743,52 531,00 379,20 271,11 270,81 271,11 135,41
 EAS Full-Line Project Calculations
1. Increase in Sales
Cost savings estimation

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Average shrink without EAS 3,60% 3,82% 4,03% 4,25% 4,46% 4,68% 4,68% 4,68% 4,68% 4,68%
Shrinkage Decline 35,00% 35,00% 35,00% 35,00% 35,00% 35,00% 35,00% 35,00% 35,00% 35,00%
Gross Margin 44,70% 44,70% 44,70% 44,70% 44,70% 44,70% 44,70% 44,70% 44,70% 44,70%
Cost of Goods Sold % 55,30% 55,30% 55,30% 55,30% 55,30% 55,30% 55,30% 55,30% 55,30% 55,30%

Cash flow calculation

Investment 1 2 3 4 5 6 7 8 9 10
Revenues 500 000,00 530 000,00 561 800,00 595 508,00 631 238,48 669 112,79 709 259,56 751 815,13 796 924,04 844 739,48
Average shrink without EAS 3,60% 3,82% 4,03% 4,25% 4,46% 4,68% 4,68% 4,68% 4,68% 4,68%
Loss in Revenues 18 000,00 20 224,80 22 651,78 25 297,18 28 178,49 31 314,48 33 193,35 35 184,95 37 296,04 39 533,81
Shrinkage Decline 17,50% 35,00% 35,00% 35,00% 35,00% 35,00% 35,00% 35,00% 35,00% 35,00%
Savings from Sale 3 150,00 7 078,68 7 928,12 8 854,01 9 862,47 10 960,07 11 617,67 12 314,73 13 053,62 13 836,83
Operating Expenses (Tags) -1 564,00 -1 626,56 -1 691,62 -1 759,29 -1 829,66 -1 902,85 -1 978,96 -2 058,12 -2 140,44 -2 226,06 -2 315,10
Depreciation -433,84 -743,52 -531,00 -379,20 -271,11 -270,81 -271,11 -135,41 0,00 0,00
EBIT -1 564,00 1 089,60 4 643,54 5 637,84 6 645,16 7 688,51 8 710,30 9 288,44 10 038,88 10 827,56 11 521,73
Taxes 609,96 -424,94 -1 810,98 -2 198,76 -2 591,61 -2 998,52 -3 397,02 -3 622,49 -3 915,16 -4 222,75 -4 493,47
Net Income -954,04 664,65 2 832,56 3 439,08 4 053,55 4 689,99 5 313,28 5 665,95 6 123,72 6 604,81 7 028,26

Add Back Depreciation 0,00 433,84 743,52 531,00 379,20 271,11 270,81 271,11 135,41 0,00 0,00
Net Working Capital 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00
Operating Cash Flow -954,04 1 098,50 3 576,08 3 970,08 4 432,74 4 961,11 5 584,09 5 937,06 6 259,12 6 604,81 7 028,26
Investment (Capex) -3 036,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00
Net Cash flows -3 990,04 1 098,50 3 576,08 3 970,08 4 432,74 4 961,11 5 584,09 5 937,06 6 259,12 6 604,81 7 028,26
 EAS Full-Line Project Calculations
2. Lower COGS
Cost savings estimation

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Average shrink without EAS 3,60% 3,82% 4,03% 4,25% 4,46% 4,68% 4,68% 4,68% 4,68% 4,68%
Shrinkage Decline 35,00% 35,00% 35,00% 35,00% 35,00% 35,00% 35,00% 35,00% 35,00% 35,00%
Gross Margin 44,70% 44,70% 44,70% 44,70% 44,70% 44,70% 44,70% 44,70% 44,70% 44,70%
Cost of Goods Sold % 55,30% 55,30% 55,30% 55,30% 55,30% 55,30% 55,30% 55,30% 55,30% 55,30%

Cash flow calculation

Investment 1 2 3 4 5 6 7 8 9 10
Revenues 500000,00 530000,00 561800,00 595508,00 631238,48 669112,79 709259,56 751815,13 796924,04 844739,48
Cost of goods 276500,00 293090,00 310675,40 329315,92 349074,88 370019,37 392220,53 415753,77 440698,99 467140,93
COGS adjusted from shrink 266891,89 282316,79 298634,46 315896,63 334158,06 353476,66 374685,26 397166,38 420996,36 446256,14
Differential COGS 9608,11 10773,21 12040,94 13419,29 14916,82 16542,71 17535,27 18587,39 19702,63 20884,79
Shrinkage Decline 17,50% 35,00% 35,00% 35,00% 35,00% 35,00% 35,00% 35,00% 35,00% 35,00%
Cost Savings 1681,42 3770,62 4214,33 4696,75 5220,89 5789,95 6137,34 6505,59 6895,92 7309,68
Operating Expenses (Tags) -1564,00 -1626,56 -1691,62 -1759,29 -1829,66 -1902,85 -1978,96 -2058,12 -2140,44 -2226,06 -2315,10
Depreciation -433,84 -743,52 -531,00 -379,20 -271,11 -270,81 -271,11 -135,41 0,00 0,00
EBIT -1564,00 -378,99 1335,48 1924,05 2487,90 3046,93 3540,18 3808,11 4229,74 4669,86 4994,57
Taxes 609,96 147,80 -520,84 -750,38 -970,28 -1188,30 -1380,67 -1485,16 -1649,60 -1821,25 -1947,88
Net Income -954,04 -231,18 814,65 1173,67 1517,62 1858,62 2159,51 2322,95 2580,14 2848,62 3046,69

Add Back Depreciation 0,00 433,84 743,52 531,00 379,20 271,11 270,81 271,11 135,41 0,00 0,00
Net Working Capital 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00
Operating Cash Flow -954,04 202,66 1558,16 1704,66 1896,81 2129,74 2430,32 2594,06 2715,55 2848,62 3046,69
Investment (Capex) -3036,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00
Net Cash flows -3990,04 202,66 1558,16 1704,66 1896,81 2129,74 2430,32 2594,06 2715,55 2848,62 3046,69
 EAS Full-Line Project Calculations
3. Higher Gross Margin
Cost savings estimation

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Average shrink without EAS 3,60% 3,82% 4,03% 4,25% 4,46% 4,68% 4,68% 4,68% 4,68% 4,68%
Shrinkage Decline 35,00% 35,00% 35,00% 35,00% 35,00% 35,00% 35,00% 35,00% 35,00% 35,00%
Gross Margin 44,70% 44,70% 44,70% 44,70% 44,70% 44,70% 44,70% 44,70% 44,70% 44,70%
Cost of Goods Sold % 55,30% 55,30% 55,30% 55,30% 55,30% 55,30% 55,30% 55,30% 55,30% 55,30%

Cash flow calculation

Investment 1 2 3 4 5 6 7 8 9 10
Revenues 500 000,00 530 000,00 561 800,00 595 508,00 631 238,48 669 112,79 709 259,56 751 815,13 796 924,04 844 739,48
Average shrink without EAS 3,60% 3,82% 4,03% 4,25% 4,46% 4,68% 4,68% 4,68% 4,68% 4,68%
Loss in Revenues 18 000,00 20 224,80 22 651,78 25 297,18 28 178,49 31 314,48 33 193,35 35 184,95 37 296,04 39 533,81
Shrinkage Decline 17,50% 35,00% 35,00% 35,00% 35,00% 35,00% 35,00% 35,00% 35,00% 35,00%
Savings from EAS 3 150,00 7 078,68 7 928,12 8 854,01 9 862,47 10 960,07 11 617,67 12 314,73 13 053,62 13 836,83
Differential Gross Margin 1 408,05 3 164,17 3 543,87 3 957,74 4 408,52 4 899,15 5 193,10 5 504,69 5 834,97 6 185,06
Operating Expenses (Tags) -1 564,00 -1 626,56 -1 691,62 -1 759,29 -1 829,66 -1 902,85 -1 978,96 -2 058,12 -2 140,44 -2 226,06 -2 315,10
Depreciation -433,84 -743,52 -531,00 -379,20 -271,11 -270,81 -271,11 -135,41 0,00 0,00
EBIT -1 564,00 -652,35 729,03 1 253,59 1 748,89 2 234,56 2 649,38 2 863,87 3 228,84 3 608,91 3 869,96
Taxes 609,96 254,42 -284,32 -488,90 -682,07 -871,48 -1 033,26 -1 116,91 -1 259,25 -1 407,47 -1 509,29
Net Income -954,04 -397,94 444,71 764,69 1 066,82 1 363,08 1 616,12 1 746,96 1 969,59 2 201,43 2 360,68

Add Back Depreciation 0,00 433,84 743,52 531,00 379,20 271,11 270,81 271,11 135,41 0,00 0,00
Net Working Capital 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00
Operating Cash Flow -954,04 35,91 1 188,23 1 295,68 1 446,02 1 634,20 1 886,93 2 018,07 2 105,00 2 201,43 2 360,68
Investment (Capex) -3 036,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00
Net Cash flows -3 990,04 35,91 1 188,23 1 295,68 1 446,02 1 634,20 1 886,93 2 018,07 2 105,00 2 201,43 2 360,68
 EAS Full-Line Project Results

• As a result of our calculations, we have a NPV of $33.5 million highly driven by the
increase in sales
• IRR is at 44,90%, well above the WACC which is a second good indicator for this
project
• Profitability index is at 8,29 which shows that the company will earn 8 times more
profit on their investment
 EAS Hardware Project Inputs
Inputs in K$
• WACC used is the one we calculated earlier
Sales (23 Full-Line Stores) 406 000,00 Assumptions
in Q2
Sales Growth % 9,00% Outputs • Shrinkage decline used is 35% as the studies
Cost of Goods Sold % 59,20%
shown a fell in shrinkage between 20% and
Gross Margin 40,80%
50% and Murphy’s managers would not want
Cost of Capital (WACC) 13,20%
Shrinkage 3,10%
to be too optimistic
Shrinkage Decline 35,00% • Our assumption behind the annual growth
Inflation 4,00%
rate of shrink is our average shrink without
Tax Rate 39,00%
Annual Growth in Shrinkage Rate without EAS 0,28%
EAS in 2007 multiply by the expected annual
Investment (Capex) 2 090,00 sales growth
Cost of Goods (Tags) 220,00

Depreciation table

1 2 3 4 5 6 7 8,00
MACRS table 14,29% 24,49% 17,49% 12,49% 8,93% 8,92% 8,93% 4,46%
Depreciation of cost of capital/store 298,66 511,84 365,54 261,04 186,64 186,43 186,64 93,21
EAS Hardware Project Results
Based on the same logic for the calculation than for Full-Line stores and the
assumptions present before, the results of our calculations are as follow:

• As a result of our calculations, we have a NPV of $47 million also mainly driven by
the increase in sales
• IRR is at 80,35%, well above the WACC which is a second good indicator for this
project
• Profitability index is at 21,38 which shows that the company will earn 21 times
more profit on their investment
Evaluation of Lighting Replacement
Project
• The lighting project is anticipated to save energy and lower operating costs
• The benefits are expected in three areas:
• Improve brightness and visibility up to 75%
• Energy cost savings at estimated range of 30%-40%
• Support the company’s sustainability goals
•The analysis is based on energy cost savings at estimated range of 30%-40%
as both the improving in brightness and the support on sustainability goals are
hard to quantify
 Lighting Replacement Project
Inputs
Inputs in k$
• Energy consumption used is
Reduction in nergy consumption 35,00% Assumptions 35% as energy cost savings
Cost per store 37,40 Outputs are estimated in a range of
Average consumption/h/store in kWh 56,90 30%-40%
Number of h/y 5100,00
Cost of energy (in $) 0,075 • WACC used is the one we
AC reduction/h/store in kWh 9,50 calculated earlier in Q2
Number of h/y for AC 2000,00
Taxes 39,00%
WACC 11,14%

Depreciation table

1 2 3 4 5 6,00 7,00 8,00

MACRS table 14,29% 24,49% 17,49% 12,49% 8,93% 8,92% 8,93% 4,46%
Total cost of capital/store 5,34 9,16 6,54 4,67 3,34 3,34 3,34 1,67
 Lighting Replacement Project
Cost savings estimation
Calculations
Savings on lightning 7,62
Savings on AC 1,43
Cost of energy/year/store 9,04

Cash flow calculation

Investment 1 2 3 4 5 6 7 8 9 10
Capex 37,40
Cost Savings 4,52 9,04 9,04 9,04 9,04 9,04 9,04 9,04 9,04 9,04
Depreciation -5,34 -9,16 -6,54 -4,67 -3,34 -3,34 -3,34 -1,67 0,00 0,00
EBIT -0,82 -0,12 2,50 4,37 5,70 5,71 5,70 7,37 9,04 9,04
Taxes 0,32 0,05 -0,98 -1,70 -2,22 -2,23 -2,22 -2,88 -3,53 -3,53
Net income -0,50 -0,07 1,53 2,67 3,48 3,48 3,48 4,50 5,52 5,52
Add Back Depreciation 5,34 9,16 6,54 4,67 3,34 3,34 3,34 1,67 0,00 0,00
Net Cash flows -37,40 4,84 9,09 8,07 7,34 6,82 6,82 6,82 6,17 5,52 5,52

• With savings on lightning equals to the reduction on energy consumption x average consumption/hour/store x
number of hours/year x cost of energy. The result is dividing by 1000 in order to be in k$ and be able to compare with
other projects.
• With savings on AC equals to number of hours/year the company use AC x AC reduction/hour/store x cost of
energy
 Lighting Replacement Project
Results

• As a result of our calculations, we have a NPV of $0,5 million which is much

below other project’s NPV
• IRR is at 12,83%, quite as high as the WACC therefore the project is highly
sensitive in case the WACC increases
• Profitability index is at 1,07 which shows that the company will only make a
small profit on their investment
Key Value Drivers & Major Risks

Key Value Major

Projects Drivers How do we know this?
Average shrink Big impact on total savings
Risks/Uncertainties:
EAS Sales increase Shrinkage decrease will increase sales growth • Risk-free rate
Cost savings No replenishment of stolen goods
• Market rate
Electricity efficiency by decreasing energy
Lighting Cost savings demand • Company’s internal
Replaceme
nt
Service quality Increase visibility and light risk
Sustainability Environmentally friendly
• Consumer behavior
Fluctuations have a big and direct impact on
Both Discount rate cash flows
Projects Threshold for how much higher the discount
IRR rate might be
 WACC Calculation
Using the CAPM model

WACCCalculation
Tax rate 39%

Capital structure 100% 100% 100%

Debt 20% 20% 20% • As most Murphy’s investments are matched by
Equity 80% 80% 80% the lifetime of medium term Treasury notes and
spreads, we use medium term T-notes (4.5%) as a proxy
Worst Case Base Case Best Case for the risk free rate, and Rm-Rf (7%) as the risk
market premium
Cost of Equity 15,40% 12,90% 11,65%
Risk free 5,0% 4,5% 4,5% • The company uses investment grade bond yields to
Beta 1,3 1,2 1,1 determine the cost of debt, and Grade A corporate
Risk market premium 8,00% 7,00% 6,50% bonds have a rate of 6.75%

Cost of Debt 7,25% 6,75% 6,75%

Corporate bonds (A) 7,25% 6,75% 6,75%

WACC 13,20% 11,14% 10,14%

 Scenario Analysis
Based on WACC sensitivity

$50,01 WACC Effect on NPV by Project

$60,000.00 $47,08
2.12 3.46 $41,67
$35,97
$50,000.00 $33,54 5.82
9.86 $29,03
$40,000.00 1.66
1.64
$30,000.00
-
$20,000.00
$796.5 $483.7 $102.0
$10,000.00
8 6 2
$0.00
10.14% 11.14% 13.20%
-$10,000.00
EAS Full-line Stores EAS Hardware Stores

• As we can see from the chart, EAS projects have a positive NPV even if we assume
a WACC at c. 2% higher than our calculations
• However, the Lighting Replacement project has a negative NPV in the worst case
scenario which highlight that the project is highly sensible with WACC changes
 Scenario Analysis
Our worst case scenario for both EAS Project

• First, we assumed a growth sales increase of 3% instead of 6% for Full-line stores and a
growth sales rate of 4,5% instead of 9% for Hardware stores
• Also, we assumed a shrinkage decline of 25% instead of 35% for both projects
• Finally, we used our worst case WACC which is 13,20%
• Even based on the
EASFull-line Stores Total Differential Sales Differential COGS Differential Gross Margin worst case scenario,
NPV $4 978,65 $7 352,46 -$476,71 -$1 897,11 EAS project has a
IRR 18,25% 43,12% 10,55% 1,09% positive NPV and IRR
Profitability Index 2,08 2,84 0,88 0,52 above the WACC
Investment $4 600,00
• We can safely
EASHardware Stores Total Differential Sales Differential COGS Differential Gross Margin
reassure the capital
NPV $41 675,82 $22 408,71 $11 636,62 $7 630,49
committee that this
IRR 80,35% 111,20% 73,20% 56,65%
Profitability Index 19,04 11,07 6,23 4,43
project has strong
Investment $2 310,00 financials and will
more likely be
profitable
 Recommendations
• Both projects are suitable for investment: positive NPV, IRR greater than WACC, and PI is >
1
• Based on the above analysis, EAS project has higher NPV, IRR, and PI than Lighting
Replacement project. Murphy should invest its limited capital in EAS project and reduce
stolen merchandise from the stores. This project will increase profitability even on a
calculated worst case scenario
• As for the WACC, Murphy should have a base rate for average projects (11.14%), with higher
premium added to new business projects that are riskier. The lighting replacement project in
this case is more risky, and should be attributed a higher discount rate
• The company can also invest the rest of the capital budget ($90k) on lighting replacement in
some of the hardware stores. This would support the company’s sustainability goals and
meets management’s requirements