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The Gap, Inc. – Analysis of Capital Project Proposal University of Maryland, University College FINC 430

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The Gap, Inc. – Analysis of Capital Project Proposal I.

Introduction Historically, The Gap, Inc. (GPS) has invested quite heavily in capital projects to enhance

competitive advantage. The majority of GPS’ capital expenditures in recent years have been related to the opening of new stores or enhancement of current stores among its five brands: Gap, Old Navy, Banana Republic, Athleta, and Intermix [ CITATION The16 \l 1033 ]. In 2015, 77% of GPS’ sales were in the United States, 5% in Europe, 7% in Canada, 10% in Asia, and 1% in “Other regions” [ CITATION Gra02 \l 1033 ]. To continue expanding internationally and compete in the global apparel industry, it is necessary for GPS to consider capital projects and conduct analysis to determine which project/projects add the most value for GPS. This paper will first describe the proposed capital budgeting project for GPS. An explanation of the Excel Capital Budgeting Model used in the analysis will follow. All criteria used in the analysis, including the weighted average cost of capital (WACC), the net present value (NPV), the internal rate of return (IRR), the modified internal rate of return (MIRR), and the profitability index (PI) will be explained and interpreted. The final section of this paper will recommend whether or not the proposed project should be implemented by The Gap, Inc. II.

Description of Proposed Capital Budgeting Project

Among GPS’ brands, Old Navy has been performing better than the others in recent years. In 2015, Old Navy’s global sales increased by one percent, compared to sales decreases in all other brands [ CITATION The16 \l 1033 ]. Old Navy is the only brand which has seen increases in sales during the last three fiscal years [ CITATION The16 \l 1033 ]. In fact, Old Navy’s sales made up the largest portion of GPS’ sales in 2014 and in 2015. According to GPS’ 2015 Annual

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Report, GPS will “continue to invest… through significant investments in… international expansion...” [ CITATION The16 \l 1033 ]. With expanding its global presence a top priority, GPS has been adding stores around the world. Asia has been a particularly profitable region for Old Navy in recent years. GPS opened 25 new Old Navy stores in Asia in 2014, while it opened 22 new Old Navy stores in Asia in 2015. Sales have increased for Old Navy Asia stores lately; sales were $77 million in 2013, $149 in 2014, and $194 million in 2015 [ CITATION The16 \l 1033 ]. The proposed project for GPS is to continue the expansion of the Old Navy brand by opening 30 new Old Navy stores in Asia. The acquisition of the required property and equipment needed for these 30 new stores would cost approximately $77 million dollars. An additional $15 million of inventory would be needed to open these 30 stores. In addition to the aforementioned initial outlay of $92 million, operating expenses for each store would cost over $1 million annually, totaling approximately $33.8 million annually for the thirty stores. Additional advertising expenses would cost an estimated $4.7 million annually. In the first year, GPS would experience increases in sales of approximately $61.4 million. The project will be financed through the issuance of debt. III.

Explanation of the Excel Capital Budgeting Model

The attached Excel Capital Budgeting Model was created to calculate various indicators used to evaluate a capital project. The first tab uses inputs from the second tab to calculate all cash flows for seven years, the WACC, NPV, IRR, MIRR, and PI. The second tab, “Supporting Calculations and Input”, is the input tab. All input fields are orange, while formula-based fields are light blue. This model requires inputs from the company’s balance sheet, income statement, statement of cash flows, and other information from the SEC 10-K. The provided inputs are

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used to calculate all revenues and expenses, capital expenditures, depreciation, taxes, cash flows, cumulative cash flows, and project indicators mentioned above. WACC is calculated using the following formula: (Cost of Equity * Total Equity / Total Value) + (Cost of Debt * Total Debt / Total Value) (1 – Corporate Tax Rate) and is used as the hurdle rate for this project. IV.

Explanation and Interpretation of Capital Budgeting Criteria Using the Payback Method, the payback period for this project is 5.07 years. Since GPS

will make back its initial investment after 5 years, and the stores would be expected to remain profitable for much longer than 5 years, this project’s payback period is relatively desirable. The Net Present Value (NPV) is the sum of the initial investment and the present value of all future cash flows [ CITATION McC \l 1033 ]. It indicates the value added from the project [ CITATION Gra02 \l 1033 ]. While using this technique, a project should be approved if the NPV is greater than $0; when the NPV is greater than $0, the present value of future cash flows is greater than the initial investment, increasing cash for the company. In addition, the NPV incorporates the WACC; when the NPV is greater than $0, the returns on investment are higher than the capital spending [ CITATION McC \l 1033 ]. For GPS’ Old Navy expansion project, the NPV is approximately $17.8 million; the project should be accepted based on this technique’s results. The Internal Rate of Return (IRR) is the return on investment, assuming the cash flows are reinvested into the project. While using this technique, a project should be accepted if the IRR is greater than the WACC. This indicates that the project is profitable, even at the current cost of capital [ CITATION McC \l 1033 ]. For GPS’ Old Navy expansion project, the IRR is

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9.99%, which is considerably higher than the WACC of 5.18%; therefore, the project should be accepted based on this technique’s results. The Modified Internal Rate of Return (MIRR) is the return on investment, assuming the cash flows are reinvested into the company but not into the project. While using this technique, a project should be accepted if the MIRR is greater than the WACC. This indicates that the project is profitable, even at the current cost of capital and without the direct reinvestment of cash flows [ CITATION McC \l 1033 ]. For GPS’ Old Navy expansion project, the MIRR is 7.88%, which is much higher than the WACC of 5.18%. The project should be accepted based on this technique’s results. The Profitability Index (PI) is the return per dollar on the investment [ CITATION McC \l 1033 ]. While using this technique, a project should be approved if the PI is greater than $1.00. This indicates that the project creates a profit above the weighted average cost of capital [ CITATION McC \l 1033 ]. For GPS’ Old Navy expansion project, the PI is $1.19. The project should be accepted based on this technique’s results. V.

Recommendation about Implementation of Capital Budgeting Project All of the above capital budgeting techniques returned the same recommendation for this

project; GPS should accept the project and begin implementation. The NPV is well over $17 million, both the 9.99% IRR and the 7.88% MIRR are well above the WACC of 5.18%, and the PI indicates a $1.19 gain on each $1.00 of investment. This project will help GPS to expand its global presence, which is one of the company’s primary goals [ CITATION Gra02 \l 1033 ]. Since all indicators returned desirable results and the project will add considerable value to the company, The Gap, Inc. should open thirty new Old Navy stores in Asia.

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References Graham, J., & Harvey, C. (2002). How do CFOs make capital budgeting and capital structure decisions? Journal of Applied Corporate Finance, 8-23. McCracken, M. (n.d.). Capital Budgeting. Retrieved from TeachMeFinance: http://www.teachmefinance.com/capitalbudgeting.html The Gap, Inc. Form 10-K. (2016, March 21). Retrieved from Securities and Exchange Commission: https://www.sec.gov/Archives/edgar/data/39911/000003991116000269/fy201510-k.htm

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Appendix A – Income Statement Projections

Appendix B – Balance Sheet Projections

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Appendix C – Cash Flow Projections

Appendix D – Financial Ratio Projections

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