Abercrombie, Inc. is faced with the decision of how best to grow their company given their current available investment opportunities.
There are some unique issues to consider while analyzing these investment opportunities. Abercrombie has been at most a two-product company throughout its history as a firm, thus adding additional product lines could potentially strain the company’s production and overheard allocation. Furthermore, presses are formatted for solely one customer and cannot be altered to meet alternative production specifications. Because of this there are high switching costs as well as low scrap value, creating a necessity for long-term commitments from clients.
There are several investment opportunities that are currently available to Abercrombie in addition to their current production operations. Firstly, the company could print white pages only and keep the plant located in St. Paul. Secondly, the company could print white pages in St. Paul and build a plant in Tucson for the production of yellow pages. Thirdly, Abercrombie has the option of printing both white and yellow pages in Tucson. Lastly, Abercrombie could re-enter the magazine industry and print magazines in San Jose, CA.
Suggested Investment Action
We recommend that Abercrombie, Inc. Invest in the land in Tucson and produce both the white and yellow pages within that plant, as it yields the highest Net Present Value (NPV) of the four options.
Due to the nature of the industry and the machinery required, it is imperative that we enter into a long term contract with our clients. In valuing these contracts we must factor in the initial investment outlays for machine set-up costs (including the purchasing of new land), as well as all future cash flows of a given project. To do this we use a form of analysis known as Net Present Value (NPV). In calculating the NPV of each investment we made several assumptions, such as the discount rates given to us by Ms. Nelson accurately reflecting that of Abercrombie’s cost of capital. Furthermore, we assume that Abercrombie has the resources available to finance each of the options appropriately.
In making our suggestion we first calculated the NPV of each project in conjunction with their optimal engineering life (See Appendix A). While it was assumed the investment options involving directory press production incurred no maintenance costs, the magazine press productions do in fact incur maintenance costs. This is an important assumption because the optimal replacement cycle is much shorter when maintenance costs are involved, whereas with no maintenance costs the optimal replacement cycle is equal to the engineering life of the asset. Therefore, in valuing the magazine press production we compared the NPV for Option 1 on the basis of its optimal economic life (Appendix B)—thus giving us the appropriate optimal replacement cycle to properly value the investment option. Our analysis concluded that Option 4 generated the highest present value.
Option 1: Re-enter Magazine industry and Print Magazines in San Jose, California This investment option involves Abercrombie venturing back into the magazine production industry. Abercrombie would expand on their current product lines into that of an additional industry. As this expansion occurs, new opportunities for expansion and growth may arise.
Note: The replacement Cost in this table stems from the optimal replacement cycle, which replaces the machinery every three years (Appendix C)
While the investment does in fact have a positive NPV, there are also added negative aspects of the investment to consider. As Abercrombie discovered in their previous venture into the magazine industry, the project comes with a much greater risk as well as increased competition. Furthermore, the investment would also strain the overhead of Abercrombie as the company expanded its...