Discussion—Process Design

Assignment 1: Discussion—Process Design

Differing strategies and business models deliver products and services, using diverse operating strategies and models. These varied operating models reflect optimal solutions tailored to the uniqueness of those industries, products, and customers.

An effective operating strategy links product/services decisions with investment, market share, and product/service life cycle and defines the breadth of the product line/service. Its main goal is to meet the demands of the marketplace with a competitive advantage. A successful outcome of this process can result in the formation of seemingly unique businesses by combining tools and techniques that are widely available in a very peculiar and unique way.

Using the module readings,  University online library resources, and the Internet, research these tools and techniques. Based on your research respond to the following:

  • What are the various process strategies, and under what circumstances are they best used?
  • Which strategies are used in your business or a business you would like to work in? What process analysis and design tools are used? For example, a matrix may be a valuable tool for most businesses.

Write your initial response in approximately 300–500 words. Apply APA standards to citation of sources.

 

Assignment 1 Grading Criteria
Appropriately explained the application of at least two process strategies and showed in-depth analysis of business environment.
Analyzed the selected business to identify the process strategies, process analysis, and design tools used.

 

Assignment 2: LASA 2—Company Analysis Report

Review the following scenario:

Assume that you have recently been hired as the director of continuous improvement of a company. You are an outside hire with limited history of the firm and personal capital at the firm, and you are responsible for lean production, total quality management (TQM), six sigma, and best practice implementation.

Lean production means doing more with less, such as less inventory, fewer workers, or less space. A recent trade in quality management is lean six sigma (also known as lean sigma) that integrates six sigma and lean production.

The capacity for which you were hired has existed for three years with a direct line of report to the vice-president of operations and dotted line of report to the head of information technology (IT), the chief information officer (CIO), and the director of internal controls and audit. You are the second person to fill in this position. You have a team of internal consultants; half of your team has six sigma black belt or equivalent capabilities with the remainder having a solid understanding of operations and IT. You also have a budget for two external vendor resources.

You have taken six months to familiarize yourself with the organization and its people, mission, goals, strategy, and structure. In this time, you have also evaluated current operations. At the end of this period, you are assigned to deliver a report identifying the three most promising avenues for achieving best practices within the company. You have already been told that the company suffers from both aging and complex information systems and that your recommendation must include a major upgrade of those systems. The executive officers anticipate major investments in IT over the next several years. Your best practice implementations, coupled with new technology, must be measurable in terms of speed, quality, productivity, and efficiency or other key performance indicators that you identify in your report.

For this assignment, you will choose a company with which you are familiar. You are encouraged to choose a company for which you currently work or have worked, but you may choose some other firm if you believe it will be a compelling analysis.

You may choose one area of the company, such as a manufacturing plant or product design, to focus on if you can make a strong case. Your recommendations should have the following features.

  • Repeatable: If you “fix” three things in a manufacturing plant, you should be able to tackle the “next” three in iteration.
  • Scalable: If they work in one plant, they should work in all of them.
  • Replicable: Your process for improvement should be repeatable in different, disparate parts of the organization.

This is a key initiative at the “C” level, and your recommendation will reach the board of directors.

Your paper must include the following sections:

  • Strategic Overview: (1 page)
    Provide a brief description of the following elements:

    • The company, including its products or services
    • Marketing strategy: target market segments, value proposition, market position, and source of competitive differentiation
    • Organizational structure
    • Any other relevant facts
  • Analysis of the Supply Chain: (4 pages)
    Analyze the supply chain for your identified company by explaining the following key elements of the supply chain:

    • Identify key inputs, including less tangible assets, such as human resources and information. How are these key inputs sourced, reconfigured into a product or service, and delivered to your customers?
    • Identify the key processes that add value, and evaluate the supply chain performance relative to the competition. What are the key inputs for each process? How are these inputs processed or configured into the final offering for your customers?
    • What is the value added at each step?
    • What is the role of information technology and e-commerce in serving your customers?
    • What are the key performance measures for evaluating your supply chain?
    • Research online sources to explain how the performance on these measures compares to that of your competitors?
  • Plan to Improve Operating Processes: (3 pages)
    Create a plan for improving the performance of three specific operating processes in your company. Your plan should address the following:

    • Identify three elements of the supply chain that you recommend as targets for improvement.
    • State the performance improvement opportunity for each element, and indicate how it will improve process speed, quality, efficiency, and productivity.
    • Explain what specific action or change you recommend for each supply chain element selected.
  • Explanation of the Results of Performance Improvements Regarding Product or Service: (2 pages)
    Explain the following:

    • How will your product or service be improved as a result of these changes to the supply chain activities?
    • How are you altering the specific features or attributes of your product or service?
    • Why are these specific changes important to your customers?
    • How do these changes enhance the value proposition and competitive position of your company?
    • What lasting capabilities and improvement are you introducing into your company through these changes?
    • How will you measure the scope and impact of your improvements? What are your key performance indicators?
  • Assessment of the Impact on Human Resources: (1–2 pages)
    Detail how your plan impacts your company’s HR and human capital strategy by explaining how the organization’s structure supports the new process configuration you are recommending. Your response should address the following questions:

    • Are the roles and responsibilities in your organization properly defined and aligned to enable these changes? Who will perform these new/modified process activities, and what changes to their jobs do you anticipate?
    • Is decision-making authority assigned so that the process changes you propose can be implemented and properly managed under the current structure? Who will own the process and the results? Based on the current structure, will they have the authority to make changes as necessary?
    • Are the individuals with the right skills in place to implement these changes? If not, how will you attract the talent necessary to implement your changes? How will you retrain the existing employee base? How will you handle attrition? How will you reduce the risk of impacted protected classes?
  • Changes:
    Explain changes to the compensation and incentives at your company that are necessary to reinforce your recommendations and increase efforts for continuous improvement throughout the organization. Explain how your plan motivates employees, customers, and suppliers better.

Write a 10-page paper in Word format. You may rearrange the above sections if it improves the quality of your paper.

LASA 2—Company Analysis Report Rubric

NOTE: If a component is absent, student receives a zero for that component Exemplary

90–100%

(A- to A)

.

Synthesis includes clear discussion of company’s specific products and services; in-depth discussion of marketing strategy; and a detailed organizational structure. Discussion is supported by additional relevant facts and examples regarding the company’s structure and services. Scholarly evidence is used to support ideas throughout.
 
Analysis of the supply chain examines all its key inputs including source, reconfiguration, and delivery to the customer. For each step, several processes that add value, relative to the competition, are identified and compared. Synthesis examines and analyzes the role of info-technology and ecommerce in meeting customer needs. The key performance criteria used for evaluating the supply chain are accurate, measureable, and are evaluated against what many other competitors utilize for measurement. Scholarly evidence is used to support ideas throughout.
Performance improvement plan diagnoses current supply chain and isolates three or more elements in need of improvement. Several innovative improvement opportunities are explained and justified. Explanation includes multiple details regarding process speed, quality, efficiency, etc. Scholarly evidence is used to support ideas throughout.
Synthesis outlines performance results in detail based on improvement recommendations.

Related changes to the product or service are discussed including how these changes meet customer needs. A logical and detailed justification for how these changes will enhance the value proposition and competitive positioning is included. Many logical and effective means for measurement are outlined that include key performance indicators for success. Scholarly evidence is used to support ideas throughout.

Synthesis utilizes research and data to analyze how the plan affects the company’s HR and human capital strategy.

The analysis includes several details and examples regarding alignment with roles, decision-making authority, existing employee talent, and compensation.

Writing is clear, concise, and well organized. It demonstrates ethical scholarship in accurate representation and attribution of sources and displays accurate spelling, grammar, and punctuation.

 

 
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Finance Disscussion 3

STEPHEN A. ROSS Massachuset ts Ins t i tu te o f Technolog y

RANDOLPH W. WESTERFIELD Univer s i t y o f Southern Ca l i fo rn ia

BRADFORD D. JORDAN Univer s i t y o f Kentucky

GORDON S. ROBERTS Schul ich School o f Bus iness , Yor k Univer s i t y

Fundamenta l s o f

Corporate Finance

Eighth Canadian Edition

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Fundamentals of Corporate Finance Eighth Canadian Edition

Copyright © 2013, 2010, 2007, 2005, 2002, 1999 by McGraw-Hill Ryerson Limited, a Subsidiary of The McGraw-Hill Companies. Copyright © 1996, 1993 by Richard D. Irwin, a Times Mirror Higher Education Group, Inc. company. All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means, or stored in a data base or retrieval system, without the prior written permission of McGraw-Hill Ryerson Limited, or in the case of photocopying or other reprographic copying, a license from The Canadian Copyright Licensing Agency (Access Copyright). For an Access Copyright licence, visit www.accesscopyright.ca or call toll free to 1-800-893-5777.

Statistics Canada information is used with the permission of Statistics Canada. Users are forbidden to copy this material and/or redisseminate the data, in an original or modified form, for commercial purposes, without the expressed permission of Statistics Canada. Information on the availability of the wide range of data from Statistics Canada can be obtained from Statistics Canada’s Regional Offices, its World Wide Web site at http://www.statcan.gc.ca and its toll-free access number 1-800-263-1136.

The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a Web site does not indicate an endorsement by the authors or McGraw-Hill Ryerson, and McGraw-Hill Ryerson does not guarantee the accuracy of information presented at these sites.

ISBN-13: 978-0-07-105160-6 ISBN-10: 0-07-105160-0

1 2 3 4 5 6 7 8 9 0 QGV 1 9 8 7 6 5 4 3

Printed and bound in the United States of America.

Care has been taken to trace ownership of copyright material contained in this text; however, the publisher will welcome any information that enables it to rectify any reference or credit for subsequent editions.

Director of Product Management: Rhondda McNabb Senior Product Manager: Kimberley Veevers Marketing Manager: Jeremy Guimond Senior Manager, Development: Kelly Dickson Senior Product Developer: Maria Chu Senior Product Team Associate: Christine Lomas Photo/Permissions Research: Maria Chu Supervising Editor: Joanne Limebeer Copy Editors: Armour Robert Templeton, Bradley T. Smith/First Folio Resource Group Inc. Production Coordinator: Tammy Mavroudi Cover Design: Word & Image Cover Images: Modern architecture (Vetta archives), columns (Philip and Karen Smith) Interior Design: Word & Image Page Layout: Tom Dart/First Folio Resource Group Inc. Printer: Quad/Graphics Versailles

Library and Archives Canada Cataloguing in Publication

Fundamentals of corporate finance / Stephen A. Ross … [et al.].—8th Canadian ed. Includes bibliographical references and indexes.

ISBN 978-0-07-105160-6

1. Corporations—Finance—Textbooks.  I. Ross, Stephen A

HG4026.F86 2013               658.15               C2012-906997-3

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ABOUT THE AUTHORS

Stephen A. Ross Sloan School of Management, Franco Modigliani Professor of Finance and Economics, Massachusetts Institute of Technology

Stephen A. Ross is the Franco Modigliani Professor of Finance and Economics at the Sloan School of Management, Massachusetts Institute of Technology. One of the most widely published authors in finance and economics, Professor Ross is recognized for his work in developing the Arbitrage Pricing Theory and his substantial contributions to the discipline through his research in signalling, agency theory, option pricing, and the theory of the term structure of interest rates, among other topics. A past president of the American Finance Association, he currently serves as an associate editor of several academic and practitioner journals. He is a trustee of CalTech.

Randolph W. Westerf ield Marshall School of Business, University of Southern California

Randolph W. Westerfield is Dean Emeritus of the University of Southern California’s Marshall School of Business and is the Charles B. Thornton Professor of Finance. He came to USC from the Wharton School, University of Pennsylvania, where he was the chairman of the finance department and a member of the finance faculty for 20 years. He is a member of several public company boards of directors, including Health Management Associates, Inc., William Lyons Homes, and the Nicholas Applegate growth fund. His areas of expertise include corporate financial policy, investment management, and stock market price behaviour.

Bradford D. Jordan Gatton College of Business and Economics, Professor of Finance and holder of the Richard W. and Janis H. Furst Endowed Chair in Finance, University of Kentucky

Bradford D. Jordan is Professor of Finance and holder of the Richard W. and Janis H. Furst Endowed Chair in Finance at the University of Kentucky. He has a long- standing interest in both applied and theoretical issues in corporate finance and has extensive experience teaching all levels of corporate finance and financial management policy. Professor Jordan has published nu- merous articles on issues such as cost of capital, capital structure, and the behaviour of security prices. He is a past president of the Southern Finance Association, and he is co-author (with Thomas W. Miller, Jr.) of Fundamentals of Investments: Valuation and Management, 4e, a leading investments text, published by McGraw-Hill/Irwin.

Gordon S. Roberts Schulich School of Business, York University, Canadian Imperial Bank of Commerce Professor of Financial Services

Gordon S. Roberts is Canadian Imperial Bank of Commerce Professor of Financial Services at the Schulich School of Business, York University. His exten- sive teaching experience includes finance classes for un- dergraduate and MBA students, executives, and bankers in Canada and internationally. Professor Roberts con- ducts research on the pricing of bank loans and the reg- ulation of financial institutions. He has served on the editorial boards of several Canadian and international academic journals. Professor Roberts has been a consul- tant to a number of regulatory bodies responsible for the oversight of financial institutions and utilities.

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BRIEF CONTENTS

PREFACE xvii

P A R T 1

OVERVIEW OF CORPORATE FINANCE 1

1 Introduction to Corporate Finance 1 2 Financial Statements, Cash Flow, and Taxes 25

P A R T 2

FINANCIAL STATEMENTS AND LONG-TERM FINANCIAL PLANNING 53

3 Working with Financial Statements 53 4 Long-Term Financial Planning and

Corporate Growth 84

P A R T 3

VALUATION OF FUTURE CASH FLOWS 111

5 Introduction to Valuation: The Time Value of Money 111

6 Discounted Cash Flow Valuation 129 7 Interest Rates and Bond Valuation 165 8 Stock Valuation 196

P A R T 4

CAPITIAL BUDGETING 220

9 Net Present Value and Other Investment Criteria 220

10 Making Capital Investment Decisions 250 11 Project Analysis and Evaluation 288

P A R T 5

RISK AND RETURN 317

12 Lessons from Capital Market History 317 13 Return, Risk, and the Security Market Line 346

P A R T 6

COST OF CAPITAL AND LONG-TERM FINANCIAL POLICY 387

14 Cost of Capital 387 15 Raising Capital 423 16 Financial Leverage and Capital

Structure Policy 454 17 Dividends and Dividend Policy 490

P A R T 7

SHORT-TERM FINANCIAL PLANNING AND MANAGEMENT 519

18 Short-Term Finance and Planning 519 19 Cash and Liquidity Management 552 20 Credit and Inventory Management 572

P A R T 8

TOPICS IN CORPORATE FINANCE 606

21 International Corporate Finance 606 22 Leasing 634 23 Mergers and Acquisitions 655

P A R T 9

DERIVATIVE SECURITIES AND CORPORATE FINANCE 685

24 Enterprise Risk Management 685 25 Options and Corporate Securities 711 26 Behavioural Finance: Implications for

Financial Management 750

Glossary 773 Appendix A: Mathematical Tables (available on Connect) Appendix B: Answers to Selected End-of-Chapter Problems (available on Connect) Subject Index 781 Name Index 800 Equation Index 802

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CONTENTS

PREFACE xvii

P A R T 1

OVERVIEW OF CORPORATE FINANCE 1

C H A P T E R 1

INTRODUCTION TO CORPORATE FINANCE 1

1.1 Corporate Finance and the Financial Manager 1 What Is Corporate Finance? 2 The Financial Manager 2 Financial Management Decisions 2

1.2 Forms of Business Organization 4 Sole Proprietorship 4 Partnership 5 Corporation 5 Income Trust 6 Co-operative (Co-op) 7

1.3 The Goal of Financial Management 8 Possible Goals 8 The Goal of Financial Management 8 A More General Goal 9

1.4 The Agency Problem and Control of the Corporation 10 Agency Relationships 10 Management Goals 10 Do Managers Act in the Shareholders’ Interests? 10 Corporate Social Responsibility and Ethical Investing 12

1.5 Financial Markets and the Corporation 14 Cash Flows to and from the Firm 15 Money versus Capital Markets 15 Primary versus Secondary Markets 16

1.6 Financial Institutions 18

1.7 Trends in Financial Markets and Financial Management 20

1.8 Outline of the Text 21

1.9 Summary and Conclusions 22

C H A P T E R 2

FINANCIAL STATEMENTS, CASH FLOW, AND TAXES 25

2.1 Statement of Financial Position 25 Assets 26 Liabilities and Owners’ Equity 26 Net Working Capital 27 Liquidity 28 Debt versus Equity 28 Value versus Cost 28

2.2 Statement of Comprehensive Income 30 International Financial Reporting Standards (IFRS) 30 Non-Cash Items 31 Time and Costs 31

2.3 Cash Flow 32 Cash Flow from Assets 32 Cash Flow to Creditors and Shareholders 34 Net Capital Spending 36 Change in NWC and Cash Flow from Assets 36

2.4 Taxes 37 Individual Tax Rates 37 Average versus Marginal Tax Rates 37 Taxes on Investment Income 39 Corporate Taxes 39 Taxable Income 39 Global Tax Rates 40 Capital Gains and Carry-forward and Carry-back 40 Income Trust Income and Taxation 41

2.5 Capital Cost Allowance 42 Asset Purchases and Sales 43

2.6 Summary and Conclusions 45

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P A R T 2

FINANCIAL STATEMENTS AND LONG-TERM FINANCIAL PLANNING 53

C H A P T E R 3

WORKING WITH FINANCIAL STATEMENTS 53

3.1 Cash Flow and Financial Statements: A Closer Look 54 Sources and Uses of Cash 54 The Statement of Cash Flows 56

3.2 Standardized Financial Statements 57 Common-Size Statements 57 Common-Base-Year Financial Statements: Trend Analysis 59

3.3 Ratio Analysis 60 Short-Term Solvency or Liquidity Measures 61 Other Liquidity Ratios 63 Long-Term Solvency Measures 64 Asset Management, or Turnover, Measures 65 Profitability Measures 67 Market Value Measures 68

3.4 The Du Pont Identity 71

3.5 Using Financial Statement Information 73 Why Evaluate Financial Statements? 73 Choosing a Benchmark 74 Problems with Financial Statement Analysis 75

3.6 Summary and Conclusions 75

C H A P T E R 4

LONG-TERM FINANCIAL PLANNING AND CORPORATE GROWTH 84

4.1 What Is Financial Planning? 85 Growth as a Financial Management Goal 85 Dimensions of Financial Planning 86 What Can Planning Accomplish? 86

4.2 Financial Planning Models: A First Look 88 A Financial Planning Model: The Ingredients 88 A Simple Financial Planning Model 89

4.3 The Percentage of Sales Approach 90 An Illustration of the Percentage of Sales Approach 90

4.4 External Financing and Growth 95 External Financing Needed and Growth 95 Internal Growth Rate 97 Financial Policy and Growth 98 Determinants of Growth 100 A Note on Sustainable Growth Rate Calculations 101

4.5 Some Caveats on Financial Planning Models 103

4.6 Summary and Conclusions 103

Appendix 4 (available on Connect)

P A R T 3

VALUATION OF FUTURE CASH FLOWS 111

C H A P T E R 5

INTRODUCTION TO VALUATION: THE TIME VALUE OF MONEY 111

5.1 Future Value and Compounding 112 Investing for a Single Period 112 Investing for More than One Period 112 A Note on Compound Growth 118

5.2 Present Value and Discounting 118 The Single-Period Case 119 Present Values for Multiple Periods 119

5.3 More on Present and Future Values 121 Present versus Future Value 121 Determining the Discount Rate 122 Finding the Number of Periods 124

5.4 Summary and Conclusions 126

C H A P T E R 6

DISCOUNTED CASH FLOW VALUATION 129

6.1 Future and Present Values of Multiple Cash Flows 129 Future Value with Multiple Cash Flows 129 Present Value with Multiple Cash Flows 131 A Note on Cash Flow Timing 134

6.2 Valuing Level Cash Flows: Annuities and Perpetuities 135 Present Value for Annuity Cash Flows 135

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Future Value for Annuities 140 A Note on Annuities Due 141 Perpetuities 142 Growing Perpetuities 143 Formula for Present Value of Growing Perpetuity 144 Growing Annuity 145 Formula for Present Value of Growing Annuity 145

6.3 Comparing Rates: The Effect of Compounding 145 Effective Annual Rates and Compounding 146 Calculating and Comparing Effective Annual Rates 146 Mortgages 147 EARs and APRs 148 Taking It to the Limit: A Note on Continuous Compounding 149

6.4 Loan Types and Loan Amortization 150 Pure Discount Loans 150 Interest-Only Loans 150 Amortized Loans 151

6.5 Summary and Conclusions 155

Appendix 6A: Proof of Annuity Present Value Formula 164

C H A P T E R 7

INTEREST RATES AND BOND VALUATION 165

7.1 Bonds and Bond Valuation 165 Bond Features and Prices 165 Bond Values and Yields 166 Interest Rate Risk 169 Finding the Yield to Maturity 170

7.2 More on Bond Features 173 Is It Debt or Equity? 173 Long-Term Debt: The Basics 174 The Indenture 174

7.3 Bond Ratings 177

7.4 Some Different Types of Bonds 178 Financial Engineering 178 Stripped Bonds 179 Floating-Rate Bonds 180 Other Types of Bonds 180

7.5 Bond Markets 181 How Bonds Are Bought and Sold 181 Bond Price Reporting 182 A Note on Bond Price Quotes 182 Bond Funds 184

7.6 Inflation and Interest Rates 184 Real versus Nominal Rates 184 The Fisher Effect 185 Inflation and Present Values 186

7.7 Determinants of Bond Yields 186 The Term Structure of Interest Rates 187 Bond Yields and the Yield Curve: Putting It All Together 188 Conclusion 189

7.8 Summary and Conclusions 190

Appendix 7A: On Duration 194

Appendix 7B (available on Connect)

C H A P T E R 8

STOCK VALUATION 196

8.1 Common Stock Valuation 196 Common Stock Cash Flows 196 Common Stock Valuation: Some Special Cases 198 Changing the Growth Rate 202 Components of the Required Return 203

8.2 Common Stock Features 205 Shareholders’ Rights 205 Dividends 206 Classes of Stock 206

8.3 Preferred Stock Features 207 Stated Value 207 Cumulative and Non-Cumulative Dividends 207 Is Preferred Stock Really Debt? 208 Preferred Stock and Taxes 209 Beyond Taxes 209

8.4 Stock Market Reporting 210 Growth Opportunities 211 Application: The Price-Earnings Ratio 211

8.5 Summary and Conclusions 213

Appendix 8A: Corporate Voting 218

Contents vii

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P A R T 4

CAPITAL BUDGETING 220

C H A P T E R 9

NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA 220

9.1 Net Present Value 221 The Basic Idea 221 Estimating Net Present Value 222

9.2 The Payback Rule 225 Defining the Rule 225 Analyzing the Payback Period Rule 225 Redeeming Qualities 226 Summary of the Rule 226 The Discounted Payback Rule 227

9.3 The Average Accounting Return 228 Analyzing the Average Accounting Return Method 229

9.4 The Internal Rate of Return 230 Problems with the IRR 233 Redeeming Qualities of the IRR 237

9.5 The Profitability Index 238

9.6 The Practice of Capital Budgeting 239

9.7 Summary and Conclusions 241

Appendix 9A: The Modified Internal Rate of Return 248

C H A P T E R 1 0

MAKING CAPITAL INVESTMENT DECISIONS 250

10.1 Project Cash Flows: A First Look 251 Relevant Cash Flows 251 The Stand-Alone Principle 251

10.2 Incremental Cash Flows 251 Sunk Costs 251 Opportunity Costs 252 Side Effects 252 Net Working Capital 253 Financing Costs 253 Inflation 253

Capital Budgeting and Business Taxes in Canada 254 Other Issues 254

10.3 Pro Forma Financial Statements and Project Cash Flows 254 Getting Started: Pro Forma Financial Statements 254 Project Cash Flows 255 Project Total Cash Flow and Value 256

10.4 More on Project Cash Flow 257 A Closer Look at Net Working Capital 257 Depreciation and Capital Cost Allowance 258 An Example: The Majestic Mulch and Compost Company (MMCC) 259

10.5 Alternative Definitions of Operating Cash Flow 263 The Bottom-Up Approach 263 The Top-Down Approach 264 The Tax Shield Approach 264 Conclusion 265

10.6 Applying the Tax Shield Approach to the Majestic Mulch and Compost Company Project 265 Present Value of the Tax Shield on CCA 266 Salvage Value versus UCC 268

10.7 Some Special Cases of Discounted Cash Flow Analysis 269 Evaluating Cost-Cutting Proposals 269 Replacing an Asset 270 Evaluating Equipment with Different Lives 272 Setting the Bid Price 273

10.8 Summary and Conclusions 276

Appendix 10A: More on Inflation and Capital Budgeting 285

Appendix 10B: Capital Budgeting with Spreadsheets 286

C H A P T E R 1 1

PROJECT ANALYSIS AND EVALUATION 288

11.1 Evaluating NPV Estimates 288 The Basic Problem 289 Projected versus Actual Cash Flows 289 Forecasting Risk 289 Sources of Value 289

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11.2 Scenario and Other What-If Analyses 290 Getting Started 290 Scenario Analysis 291 Sensitivity Analysis 293 Simulation Analysis 295

11.3 Break-Even Analysis 296 Fixed and Variable Costs 296 Accounting Break-Even 297 Accounting Break-Even: A Closer Look 299 Uses for the Accounting Break-Even 299

11.4 Operating Cash Flow, Sales Volume, and Break-Even 300 Accounting Break-Even and Cash Flow 300 Cash Flow and Financial Break-Even Points 302

11.5 Operating Leverage 304 The Basic Idea 304 Implications of Operating Leverage 305 Measuring Operating Leverage 305 Operating Leverage and Break-Even 306

11.6 Managerial Options 307

11.7 Capital Rationing 310

11.8 Summary and Conclusions 311

P A R T 5

RISK AND RETURN 317

C H A P T E R 1 2

LESSONS FROM CAPITAL MARKET HISTORY 317

12.1 Returns 318 Dollar Returns 318 Percentage Returns 319

12.2 The Historical Record 321 A First Look 323 A Closer Look 324

12.3 Average Returns: The First Lesson 324 Calculating Average Returns 324 Average Returns: The Historical Record 324 Risk Premiums 325 The First Lesson 325

12.4 The Variability of Returns: The Second Lesson 326 Frequency Distributions and Variability 326 The Historical Variance and Standard Deviation 326 The Historical Record 328 Normal Distribution 329 Value at Risk 331 The Second Lesson 331 2008 The Bear Growled and Investors Howled 331 Using Capital Market History 332

12.5 More on Average Returns 333 Arithmetic versus Geometric Averages 333 Calculating Geometric Average Returns 333 Arithmetic Average Return or Geometric Average Return? 335

12.6 Capital Market Efficiency 335 Price Behaviour in an Efficient Market 336 The Efficient Markets Hypothesis 337 Market Efficiency—Forms and Evidence 339

12.7 Summary and Conclusions 341

C H A P T E R 1 3

RETURN, RISK, AND THE SECURITY MARKET LINE 346

13.1 Expected Returns and Variances 347 Expected Return 347 Calculating the Variance 349

13.2 Portfolios 351 Portfolio Weights 351 Portfolio Expected Returns 351 Portfolio Variance 352 Portfolio Standard Deviation and Diversification 353 The Efficient Set 355 Correlations in the Financial Crisis of 2007–2009 357

13.3 Announcements, Surprises, and Expected Returns 359 Expected and Unexpected Returns 359 Announcements and News 359

13.4 Risk: Systematic and Unsystematic 360 Systematic and Unsystematic Risk 360 Systematic and Unsystematic Components of Return 361

Contents ix

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13.5 Diversification and Portfolio Risk 361 The Effect of Diversification: Another Lesson from Market History 362 The Principle of Diversification 363 Diversification and Unsystematic Risk 364 Diversification and Systematic Risk 364 Risk and the Sensible Investor 364

13.6 Systematic Risk and Beta 365 The Systematic Risk Principle 366 Measuring Systematic Risk 366 Portfolio Betas 367

13.7 The Security Market Line 368 Beta and the Risk Premium 368 Calculating Beta 372 The Security Market Line 374

13.8 Arbitrage Pricing Theory And Empirical Models 377

13.9 Summary and Conclusions 379

Appendix 13A: Derivation of the Capital Asset Pricing Model 384

P A R T 6

COST OF CAPITAL AND LONG-TERM FINANCIAL POLICY 387

C H A P T E R 1 4

COST OF CAPITAL 387

14.1 The Cost of Capital: Some Preliminaries 388 Required Return versus Cost of Capital 388 Financial Policy and Cost of Capital 388

14.2 The Cost of Equity 389 The Dividend Growth Model Approach 389 The SML Approach 391 The Cost of Equity in Rate Hearings 392

14.3 The Costs of Debt and Preferred Stock 393 The Cost of Debt 393 The Cost of Preferred Stock 394

14.4 The Weighted Average Cost of Capital 394 The Capital Structure Weights 395 Taxes and the Weighted Average Cost of Capital 396 Solving the Warehouse Problem and Similar Capital Budgeting Problems 396 Performance Evaluation: Another Use of the WACC 398

14.5 Divisional and Project Costs of Capital 399 The SML and the WACC 399 Divisional Cost of Capital 401 The Pure Play Approach 401 The Subjective Approach 402

14.6 Flotation Costs and the Weighted Average Cost of Capital 403 The Basic Approach 403 Flotation Costs and NPV 404

14.7 Calculating WACC for Loblaw 406 Estimating Financing Proportions 406 Market Value Weights for Loblaw 406 Cost of Debt 407 Cost of Preferred Shares 408 Cost of Common Stock 408 CAPM 408 Dividend Valuation Model Growth Rate 409 Loblaw’s WACC 409

14.8 Summary and Conclusions 409

Appendix 14A: Adjusted Present Value 414

Appendix 14B: Economic Value Added and the Measurement of Financial Performance 419

C H A P T E R 1 5

RAISING CAPITAL 423

15.1 The Financing Life Cycle of a Firm: Early-Stage Financing and Venture Capital 423 Venture Capital 424 Some Venture Capital Realities 424 Choosing a Venture Capitalist 424 Conclusion 425

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15.2 The Public Issue 425

15.3 The Basic Procedure for a New Issue 426 Securities Registration 427 Alternative Issue Methods 427

15.4 The Cash Offer 427 Types of Underwriting 428 Bought Deal 428 Dutch Auction Underwriting 429 The Selling Period 429 The Overallotment Option 430 Lockup Agreements 430 The Quiet Period 430 The Investment Dealers 430

15.5 IPOs and Underpricing 431 IPO Underpricing: The 1999–2000 Experience 431 Evidence on Underpricing 432 Why Does Underpricing Exist? 435

15.6 New Equity Sales and the Value of the Firm 436

15.7 The Cost of Issuing Securities 437 IPOs in Practice: The Case of Athabasca Oil Sands 439

15.8 Rights 439 The Mechanics of a Rights Offering 439 Number of Rights Needed to Purchase a Share 440 The Value of a Right 441 Theoretical Value of a Right 442 Ex Rights 443 Value of Rights after Ex-Rights Date 444 The Underwriting Arrangements 444 Effects on Shareholders 444 Cost of Rights Offerings 445

15.9 Dilution 446 Dilution of Proportionate Ownership 446 Dilution of Value: Book versus Market Values 446

15.10 Issuing Long-term Debt 448

15.11 Summary and Conclusions 449

C H A P T E R 1 6

FINANCIAL LEVERAGE AND CAPITAL STRUCTURE POLICY 454

16.1 The Capital Structure Question 455 Firm Value and Stock Value: An Example 455 Capital Structure and the Cost of Capital 456

16.2 The Effect of Financial Leverage 456 The Basics of Financial Leverage 456 Corporate Borrowing and Homemade Leverage 460

16.3 Capital Structure and the Cost of Equity Capital 462 M&M Proposition I: The Pie Model 462 The Cost of Equity and Financial Leverage: M&M Proposition II 462 Business and Financial Risk 463

16.4 M&M Propositions I and II with Corporate Taxes 466 The Interest Tax Shield 466 Taxes and M&M Proposition I 466 Taxes, the WACC, and Proposition II 468

16.5 Bankruptcy Costs 470 Direct Bankruptcy Costs 470 Indirect Bankruptcy Costs 470 Agency Costs of Equity 471

16.6 Optimal Capital Structure 472 The Static Theory of Capital Structure 472 Optimal Capital Structure and the Cost of Capital 473 Optimal Capital Structure: A Recap 473 Capital Structure: Some Managerial Recommendations 475

16.7 The Pie Again 475 The Extended Pie Model 475 Marketed Claims versus Non-Marketed Claims 476

16.8 The Pecking-Order Theory 477 Internal Financing and the Pecking Order 477 Implications of the Pecking Order 477

16.9 Observed Capital Structures 478

 
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600 Words GAP Big Data Case Analysis

9 – 517 – 115 R E V : J U L Y 10, 2017

 

A Y EL E T I S R A ELI

J I LL A V ER Y

 

Predicting Consumer Tastes with Big Data at Gap

In January 2017, Art Peck, chief executive officer and HBS MBA ‘79, was struggling to turn around Gap Inc. following two years of declining sales in an environment where many brick and mortar retailers were under pressure. Peck took over as CEO in February 2015, after serving as president of growth, innovation, and digital, when he envisioned and implemented Gap’s digital strategy using an analytical approach (see vitae in Exhibit 1). Gap’s troubles were not new to Peck; the company had been struggling to regain its footing since 2000.

One way he hoped to improve operations was to eliminate the positions of creative director for each of the firm’s fashion brands and to replace them with a more collective creative ecosystem fueled by the input of big data. Creative directors were the visionaries of a fashion brand, serving as guardians of its image and providing its taste inspiration and wellspring of ideas. These designers, such as Karl Lagerfeld for Chanel and Christopher Bailey for Burberry, established a design direction for each line, created a small number of inspiration pieces, and oversaw and approved the designs of other products in the line. Their personal vision established and reinforced the look, feel, tone, and spirit of the brand.

However, Peck was critical about the amount of power this concentrated in one individual. Many creative directors with top notch design experience had come and gone during his tenure without

making a significant mark to boost sales. Labeling creative directors “false messiahs”,1 Peck reflected, “We have cycled through so many, and each has been proclaimed as the next savior.”2 Instead of betting the future on the next savior, he replaced creative directors with a decentralized, collective process that no longer required the approval of a creative director. Rather than relying on a single person’s artistic vision, Peck pushed the company to use the mining of big data obtained from Google Analytics and the company’s own sales and customer databases as the backbone to inform the next season’s assortment. Ideas could thus arise anywhere, even from Gap’s external vendors, and would no longer have to be vetted by a creative director serving as maestro of the collection. Once a trend was spotted, it could be immediately and simultaneously incorporated into all three of the company’s brands, hitting stores within three months. “There is now science and art, and they can come together,” in this new process, proclaimed Peck.3 With the elimination of his creative directors, he was upsetting the delicate balance between creativity and commercialization, between designers and merchants, that existed at most fashion brands and that had supported Gap Inc.’s fashion cycles for decades.

Peck was also considering expanding online distribution by selling Gap’s brands on Amazon, an online retailer. His previous role at Gap taught him the importance of e-commerce and digital and he

 

 

 

Professor Ayelet Israeli and Senior Lecturer Jill Avery prepared this case. This case was developed from published sources. Funding for the development of this case was provided by Harvard Business School and not by the company. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management.

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expressed his opinion that Gap could be at a disadvantage if it didn’t consider the Amazon opportunity. Selling on Amazon could provide an additional datastream about customer purchasing

behavior to inform Gap’s decision making.4

Company Overview

Gap Inc. was founded in 1969 by Donald and Doris Fisher and their son, Robert was chairman of the board in 2017. Gap was one of the creators of specialty retailing, retailers that focused on a particular product category rather than carrying a wide assortment and produced their own private label branded goods. It remained the largest example of the genre, with 135,000 employees and 3,659 company owned and franchised retail locations in 50 countries, accounting for 36.7 million square feet of selling space,

which generated global sales of $15.5 billion.5 (Also see Exhibit 7).

Gap Inc. managed five brands: Gap, Banana Republic, Old Navy, Athleta, and Intermix, and had historically been the authority on American casual style. The Gap brand offered female and male consumers casual, classic, clean, comfortable basics: jeans, khakis, button down shirts, pocket tees — at accessible prices. Some called it democratic fashion, “ordinary, unpretentious, understated, almost lowbrow,” while others labeled it iconic: “They elevated incredible basics to not just an iconic status in terms of clothing, but also a spirit – you felt like there was such a strong attitude, so much energy.”6 In 1996, Gap was at the height of its cool; actress Sharon Stone wore a Gap turtleneck on the red carpet of the Academy Awards.

 

In 1983, Gap Inc. acquired Banana Republic, moving into a higher price/quality tier. Luxurious materials were combined with detailed craftsmanship to support more expensive price points and attract a higher income consumer. In 1994, Gap Inc. created a new brand, Old Navy, to compete with discount department stores and mass merchandisers, such as Sears and Target, ushering in a period during which it became chic for consumers of all income brackets to shop for a bargain. Offering “wardrobe must-haves” at “prices you can’t believe,” embedded in a fun shopping experience, Old Navy was an immediate success with families, becoming the first retailer to reach $1 billion in annual sales within four years of its launch.7 Two acquisitions followed, Athleta (2008) a women’s fitness apparel brand, capitalized on the shift in women’s fashion from a jean-based foundation to activewear apparel. Intermix (2012) a multi-brand retailer of luxury and contemporary women’s apparel, offered consumers the “most sought-after styles” from a carefully curated selection of “coveted designers.”

 

In 1983, Millard “Mickey” Drexler became chief executive officer. During his tenure, sales grew from $480 million to $14 billion in 2000 and Gap’s market cap swelled to $42 billion. Drexler, described as “a visionary executive [that] helped transform Gap from a grab-bag of styles into a trend-setting machine that made simple clothes look great, even elegant,”8 was dubbed “the merchant prince” for his trendspotting, design instinct, and merchandising prowess. However, after being one of the first to predict the rise of business casual in the 1990’s, Drexler lost his magic touch, as he attempted to inject more fashion into Gap to attract younger shoppers who were migrating to edgier competitors. After eight consecutive quarters of declining sales, Drexler left Gap in 2002. Explained fashion writers,

Clothing companies…depend upon the vision and taste of just one person…Everything at Gap depends upon Drexler’s eye; it isn’t like making turbine engines. If he’s off the mark…if he approves a line of clothes in colors that aren’t just right, sales collapse and so does Gap’s stock price. That is why Gap can never really be like

Coca-Cola – there is no Gap formula hidden in some vault; there’s only Mickey Drexler.9

 

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Two CEOs followed but were unable to restore Gap’s success in what the New York Times called “a remarkable comedown for a chain that once seemed to dictate how America dressed”10 (see Exhibit 2 for sales and net profit since Gap’s IPO in 1976 through 2016).

Every season, Gap produced hundreds of unique products, each offered in a variety of colors and sizes. While the online website typically offered the entire product assortment, each brick-and-mortar

store, with an average footprint of 10,000 square feet,11 was somewhat limited due to space constraints and offered a carefully curated subset of the product line. Gap’s assortment in each of its primary categories (women, men, children, and baby) consisted of two types of products: basics with styles that endured across seasons and more fashion-forward, designed items that captured the spirit of a particular season. Creative directors influenced the full product line, but their touch was most heavily felt on the latter group, where more fashion innovation was desired.

Digital and Big Data at Gap Inc.

As president of growth, innovation, and digital, Peck invested heavily in digital capabilities to address consumers’ shift to omnichannel shopping, focusing on dissolving the wall between the physical and digital channels. He observed, “Our customers are omni today and that is a fundamental reality. Many of our customers begin their journey with our brands on their phone and they finish it in our stores. Many of our customers begin their journey with our brands in our stores and they finish it on their phone.”12 He digitized the company’s entire product inventory and introduced retail services, such as reserve in store, find in store, and ship from store, which made it easy for customers to browse, purchase, and receive their items seamlessly across channels.

Peck promoted data-driven decision making and pushed his team to utilize big data to learn more about customers’ behaviors, and thereby deliver a better customer experience, “There’s lots of talk out there about big data—to me, big data, personalization is focused on an outcome of relevance. That’s

what we’re working on,” he explained.13 As the company moved into digital, Peck pushed his managers to continuously test and refine its new features as it listened to customers via its voice of the customer initiatives that tracked customer feedback and usage. A surprising finding arose: “Despite the explosive popularity of shopping not just online but via smartphones and tablets, 80% of Gap Inc.

customers still preferred to visit a store to try on the clothes.”14 As a result, Gap was working with Google and Avametric to develop an augmented reality app that allowed shoppers to test out different looks in order to improve their online and mobile shopping experiences.

Data-driven decision making required that customers be trackable and Peck lamented that customers were identifiable online but anonymous when they shopped in a store. He searched for ways to have customers opt-in to self-identify when they shopped in a store. He elucidated,

It is an opportunity to bring our personalization capabilities and customization relevance to bear in a store environment…60% of people visiting the website are recognized as unique visitors, enabling Gap to personalize experiences based on things like browsing and purchase history. Doing so is providing movement on numbers like conversion, time on website, click-through-rate…Good things happen for the customer if they’re willing to self-identify and tell us who they are at the beginning of a shopping experience. They do on the website, they don’t in our stores. If you come into our stores today, we won’t recognize you until you tender, if we recognize you then. This…is about providing…the opportunity to self-identify in order for the company to create a much

more relevant set of experiences compared to when they shop anonymously.15

 

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Gap developed email programs to provide relevant, personalized messages to consumers. These included rules and conditions that when run through a series of algorithms triggered an email to certain consumers. For example, if a consumer abandoned her cart, an email was sent to remind her of her forgotten goods. If it was a consumer’s birthday, a personalized greeting and promotion was offered. If one of the brands was offering a new product line in a category that a customer had previously purchased, an email notification was sent to her highlighting it. Gap also used personalization in its geosniffing efforts, a term used to describe a company’s ability to determine the physical location of a particular consumer and to send them relevant localized information in real time. Information gleaned from clickstream analysis allowed Gap to reach out to consumers who had visited one of its websites, with customized messaging based on what they were searching previously, or to deliver a different landing page based on a consumer’s browsing history and/or IP address. Peck recognized the importance of allowing customers to opt-in to this type of digital tracking, “the company is carefully walking the line between personalizing a customer’s experience in a way that’s relevant and helpful

without creeping them out…Privacy is a huge concern for us,” he avowed.16

Managing the closing of underperforming stores (200 in 2011, 175 in 2015, and 75 in 2016) was another arena in which Gap used data-driven decision making. The company used the collection of insights from consumers’ online browsing activity and engagement in social media platforms to help understand why consumers were not buying as much from Gap’s physical stores. Peck proclaimed,

Visits to good malls are not down, but the number of store visits inside a mall are down, which says to me that people are planning their store visits as a function of their engagement with the brand, oftentimes expressed on a smartphone. I would argue that nobody’s figured out what exactly the aspirational, holistic, emotional expression of a brand…looks like when it shows up on this device right now.17

This insight drove him to further develop Gap’s digital and mobile e-commerce platforms to drive customer engagement. According to Fast Company, Peck had Silicon Valley developers “camped out at Gap, Banana Republic, and Old Navy stores, incorporating customer and salesperson feedback into

code in real time.”18 Peck’s performance and analytical nature were key to his selection as CEO.

Peck as CEO: The First Two Years

Peck was appointed CEO in October 2014. He faced some key challenges:

1. Slow growth in core markets: Gap Inc. competed in the $3 trillion global apparel industry, which accounted for 2% of the world’s gross domestic product (GDP). The U.S. and Canadian markets accounted for over $250 billion and were expected to grow annually by 2% through

2025.19 These two markets accounted for 84% of Gap’s sales. Millennials were spending less on apparel. Speaking to investors at a retail conference, Peck claimed that “there are no compelling [fashion] trends driving the business” and lamented that there had been a change in consumers’

buying habits such that there was a lack of need to replenish her closet.20

2. Competition: The mid-tier apparel landscape (see Exhibit 3) was highly fragmented, overcrowded, and competitive.

 

3. Rise of e-commerce: Consumers were shifting their purchasing from brick and mortar stores to online channels. In the U.S., 19% of apparel was sold through online channels in 201621 and, in 2015, clothing became the bestselling online sales category, driven by Amazon’s increasing strength in apparel. Amazon, the world’s largest multi-line, multi-brand Internet-based retailer,

 

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was on track to become the largest seller of apparel in the U.S. by the end of 2017. As online sales grew, brands did not need the same number of storefronts. Empty stores lined the American shopping malls, as both specialty retailers and department stores simultaneously faced pressure to close locations. Gap had over 3,000 physical stores. By 2017, Gap Inc.’s online sales exceeded $2.5 billion.

4. Rise of Fast Fashion: New competitors, such as H&M and Zara compressed supply chains, delivering low priced looks knocked off from luxury fashion runways within weeks of their unveilings. With an average product cycle time of ten months, Gap lagged competitors such as Zara that could deliver products to stores within four weeks due to their consumer-responsive and decentralized buying process that allowed individual stores to order small batches of product, wait to see how consumers responded to it, and then airlift additional products to backfill the store’s inventory within days. The speed and pace of the fashion cycle was dizzying,

with new styles appearing in stores on a weekly basis in a constantly renewing fashion cycle.22

5. Heavy and frequent discounting: Clothing was increasingly commoditized as consumers viewed the lower quality fast fashion offerings as disposable, yielding a need for low prices and heavy discounting. Retail analysts were concerned about an overabundance of price promotion at Gap, where 40% discounts were common.

6. Gap’s size and ubiquity was transforming from asset to liability: Consumers, looking to forge a unique identity were moving away from Gap’s classic offerings.

Given these challenges, Peck believed that product assortment was key and that Gap’s model for selecting the right assortment was failing. The market seemed to agree. In January 2015, a retail analyst commented “They flip flop between a little trending, a little Euro, a little strip, whatever. It just gives you a headache…They’ve been redesigning the clothes for a decade because there is a total lack of clarity around who they are designing for. Who do you think their shopper is? I think it depends on

the week.”23 The flagship brand was struggling to find its place, wedged in the awkward middle between competitors’ value and premium brands (see Exhibit 4). Consumers, particularly millennials were cooling to Gap’s brands (see Exhibits 5 and 6).

While Peck knew that he was facing a 15-year-old problem that could not be fixed overnight, the results for 2015 and 2016 were disappointing (see Exhibits 7, 8, and 9 for recent financial performance).

Comparable salesa had declined for eight quarters before growing by 2% in Q4 2016 to deliver a -2% sales decline for the year, despite a 4% increase in marketing expenditures. Gap Inc.’s market cap had

dropped to $9.2 billionb and the board was looking for longer term solutions.

Peck’s Product Strategy: Big Data In, Creative Directors Out

Even prior to becoming CEO, Peck was skeptical of Gap’s creative directors. Creative directors were tastemakers, classically trained in design and using their unique eye, attitude, and personality to shape tomorrow’s fashions. They were arbiters of taste and provided legitimacy and credibility to new trends with their stamp of approval. “The creative director is God,” proclaimed a major fashion brand

executive.24 Rather than sensing or spotting existing trends, creative directors imagined and birthed them, “Creative directors are there to bring the magic to brands and product, and the magic to the

 

 

a Comparable sales include the results of Company-owned stores and sales through online channels. A store is included in the calculations when it has been operated by the Company for at least one year.

b As of January 31, 2017.

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consumer experience…They are the conjurers of that incredible feeling we get when we buy something in a store or online that we really don’t need or didn’t know we needed until we saw it.” said Daniel

Marks, chief creative officer at The Communications Store.25 Without them, a company risked its brand asset, “You knew what Gap stood for when Mickey Drexler was running it…When you don’t have a creative visionary leading a company, you can’t really establish a consistent look over a period of time

and reinforce a brand’s purpose,” declared Garret Bennett, a retail consultant.26

One of Peck’s first moves when he was appointed president of Gap North America in 2011 was to fire Gap’s head of design, Patrick Robinson. Robinson, who had designed for Giorgio Armani, Perry Ellis, and Paco Rabanne, led the design team from 2007-2011. He was a fashion insider, a friend of Anna Wintour, Vogue’s editor-in-chief, and a bit of a celebrity himself, dispensing advice in Glamour and Teen Vogue. He had been excited for his new role at Gap, “We needed to redefine all those American classics…for today. Not for 15 years ago. Not for 10 years ago.”27

After Robinson’s designs missed the mark, he blamed the poor retail execution of the company’s merchants or merchandisers. Merchants, or merchandisers, in the fashion industry were closer to the market with more of a commercial orientation. They were responsible for selecting products to craft a coherent assortment for each store to reach a particular target consumer at a particular price position. Peck explained the difference, “Design’s job is to push creatively and merchandising’s job is to

counterbalance that with a commercial orientation.”28 Merchants were market-responsive, while creative directors were market-leading. Gap’s head of merchandising, Michelle DeMartini elaborated, “I am representing the consumer, and [the creative director] is representing the future. And sometimes that creates conflict about what risks we want to take.”29

Robinson’s replacement, Rebekka Bay, was hired in 2012 following her successful launch of Cos, a modern, upscale brand designed for H&M, a leading fast fashion retailer. The Gap team had high hopes that Bay would bring her Scandinavian minimalist aesthetic and understanding of fast fashion to bear. Bay was a traditional designer, governed by her gut rather than by market research. Steve Sunnucks, global president for the Gap brand was excited by what she had to offer, “Her great skill is that while she is a trained designer, her experience in trend prediction means she takes a much broader view and thinks about the brand, the product, and the customer experience holistically.”30 Said Bay, “I’m intrigued by the process of fashion, the collective mind, how we all suddenly have a taste for the same things.”31 She explained her approach as head of 160 designers at Gap:

My role is to balance creativity and commerciality. Good design is less about taste and more about integrity…You need a very strong foundation. You have boundaries, and you can only – and I’m kind of rigid about this – you can only work within them. First, you design the most iconic piece. Then you can maybe create a seasonal version of that. If anyone is going to go beyond that, I have to agree to it.32

In January 2015, as Peck transitioned into his CEO role, he dismissed Bay, judging her design aesthetic–unadorned, simple, structured with a loose, ultramodern fit and somber black and gray palette—to be inconsistent with Gap’s optimistic brand. Bay saw it differently, claiming that “Gap is

not a design-led company and thus I had very little say in what ended up in the store.”33

At Banana Republic, creative director Marissa Webb, owner of her own eponymous fashion label, was hired in April 2014 to leverage her sensibility and credibility with younger consumers. Peck was disappointed by her first effort, “It’s had a couple of very positive impacts in terms of reestablishing some fashion credibility for the brand, but we didn’t get it 100% right…The color palette was pretty

stark…we’re still working to buy an assortment that is both commercial and fashion-oriented.”34 Webb stepped down in October 2015 after only eighteen months on the job.

 

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Neither Bay nor Webb were replaced. Instead, Peck’s solution was to eliminate the position of creative director and spread the responsibility for design of the brand’s seasonal lines to a collaborative team informed by hard data. At an investor conference, he explained his decision,

We need great design. We need great creative talent. But we need that talent to be part of a highly collaborative team every season…Where we have gone wrong oftentimes as a company is when we have put the burden of running these brands season after season on the shoulders of an inspired individual. That’s not the model for success…These are

businesses, global in scale that require a highly collaborative team to be success.35

Two former employees voiced disapproval. “Anything that has to become a consensus is an equation for dilution…Without a distinct point of view, you become like everyone else,” said Todd

Oldham, a creative director at Old Navy.36 “There are not many retailers with more resources than Gap to create the next trend…In this retail environment, you have to take risky bets to even have a chance,” said Rajiv Malik, vice president of Gap global product operations. Retail analysts were skeptical. “There’s really no fashion direction…Right now, they’re a ship without a captain,” said one.37

 

Peck formulized his approach in what he called Product 3.0 (detailed below).

Big Data and Predictive Analytics in Marketing

Digital data streams allow companies to observe their consumers’ purchase journeys and collect a detailed trail of data about their online behavior. The mining of big data could yield many actionable insights to inform managerial decision making, such as identifying consumers who were more loyal to brands, matching consumers to products they might prefer, or predicting the behaviors or characteristics that could cause consumers to churn. By uncovering patterns in past customer behavior, companies could develop heuristics or algorithm-driven protocols to customize how they treated future customers to maximize satisfaction and/or profitability. It allowed remarketing or retargeting: as companies observed that a particular visitor viewed an item online but failed to purchase it, they could immediately serve up customized digital advertising that appeared as customers surfed other websites to entice them to return and complete the purchase. As digital data streams became more accessible and robust, companies were exploring how to use datamining and machine-learning to induct consumer preferences and predict future behaviors.

Utilizing predictive analytics to sell existing products: E-commerce companies, such as Amazon and Netflix, used predictive analytics to mine data to generate personalized product recommendations for their users. These suggestions were often based on aggregate data from other users, usage patterns of similar users, or a user’s own purchase history or expressed preferences, generally gathered through reviews of existing purchases or through preference polling. Offline retailers used purchase histories, accessed as customers swiped a loyalty card at checkout, to drive algorithms that determined which consumers should receive coupons or promotions. In 2012, to the dismay of her father, a teenage girl received coupons for baby clothes from Target. The retailer’s data algorithms predicted that she was pregnant even before she herself knew that she was.38

Amazon had recently patented “anticipatory shipping.” The idea was to move beyond merely providing recommendations to consumers, and instead, anticipate, based on the consumer’s historical behavior, when the consumer would need an item. Using information such as previous orders, product searches, wish lists, shopping-cart contents, returns, and even how long an Internet user’s cursor hovered over an item, Amazon would preemptively ship products to a distribution center close to the

 

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consumer, in anticipation of an incoming order. This would reduce the time lag between ordering and receiving a package to dissuade consumers from feeling the need to visit physical stores.39

 

Utilizing predictive analytics for new product development: Beyond making viewing recommendations, Netflix used data to make decisions on which new series and movies to develop. However, its CEO Reed Hastings cautioned, “We start with the data but the final call is always gut. It’s informed intuition. Data science simply isn’t sophisticated enough to predict whether a product will

be a hit.”40 Stitch Fix, an online styling service that delivered a personalized shopping experience by curating outfits for consumers based on their expressed preferences, aggregated all of its consumer preference data to learn which fashion elements were popular and then used that insight to design its own private-label fashion products.

Some companies utilized secondary data to anticipate market trends. L’Oreal Paris analyzed data from Google searches, social media sites (YouTube, Facebook, and Instagram), and fashion magazines to create a new product, the Do-It-Yourself Ombré hair coloring kit, that leveraged the ombré trend that was surging in popularity. Ocean Spray used Twitter streams to unveil flavors consumers traditionally associate with cranberries to inform novel flavor combinations.

Predicting Consumer Preferences

Predicting consumers’ future fashion tastes was a difficult proposition. Traditional market research methods, such as surveys, focus groups, and interviews, were often inadequate, as consumers were notoriously poor at predicting their future behaviors. Consumers were often unable to imagine changes in fashion, so conducting research with them was futile. Automotive pioneer Henry Ford proclaimed:

“If I had asked people what they wanted, they would have said ‘a faster horse.’“ Or, as the innovative

chef Ferran Adrià put it: “Creativity comes first. Then comes the customer.”41

Relying upon past purchase behavior was also problematic as research in consumer psychology showed that consumers’ preferences were constructed rather than revealed, subject to marketers’ manipulation, unstable over time, and therefore unpredictable. While most consumers believed that they were cognitively in charge of their decisions and thus master of their own tastes and preferences, countless experimental manipulations demonstrated that one’s choices could be swayed by elements of the decision or social context, information framing effects, and the knowledge, ability, goals, biases, and emotional state of the decider.

While taste was defined as an individual’s attitude toward an aesthetic object, fashion, was a social construct that relied upon collective behavior of many people carrying out the same or similar tastes at the same time. A consumer’s individual tastes developed within the context of social influences, including the tastes of others around them, their membership in a variety of subgroups, and the prevailing fashions of the time.42 Distinctions in taste helped mark members of different social classes

and people who occupied the same group tended to share aesthetic preferences.43

What was in and out of fashion was constantly changing, driven both by a self-dynamic process and by tastemakers. Changes happened naturally as people craved newness when yesterday’s fashion had become boring or commonplace. Because people rely on fashion to both fit in with and stand out from others, as soon as a fashion trend broadly permeated society, it stopped being fashionable.

Sociologists theorized a ratchet effect in tastes, where persistent movements in one direction were

suddenly and unexpectedly reversed and followed by movements in the other direction.44 In the short term, new tastes were generally based on existing tastes; thus, year-to-year shifts in fashion were often

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modest. But, suddenly and unexpectedly, the taste changed significantly, ratcheting in a non-linear step change to another direction. Hemlines are an illustrative example. Women’s skirts get progressively shorter as each season embraces the miniskirt, but tries to make it look different from the previous season. However, once miniskirts become ubiquitous, short skirts appear unfashionable, so the next season’s look might suddenly feature long, floor sweeping skirt lengths.

Fashion cycles were often initiated by designers, artists, fashion innovators, and other creative gatekeepers. These tastemakers constantly swept the culture looking for inspiration and ideas to combine in new ways. Their creative inventions often became the raw materials for changing fashion.

 
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Harvard Case Study: Winfield Refuse Management Financial Statement Analysis CLASS

You have been hired as an advisor to the Board of Directors of Winfield Refuse Management to guide the board in their choice of funding for the acquisition of Mott-Pliese Integrated Solutions.  In a one-page memo, make and defend a recommendation about whether the company should use debt or equity to fund the acquisition.  Be sure that your discussion addresses the issues and concerns raised by members of the board.

I have attached the do’s and don’ts. I need an A/B grade this time. It needs to a one page memo only (single spaced, times new roman, 12 size) and a second page with exhibits and calculations/tables with why you chose it.

The final decision should get to choosing the debt.

Include FRICTO analysis in the one page memo- example

https://www.investment-and-finance.net/financial-analysis/f/fricto.html

Start it by

Memo

To: Board of Directors of Winfield Refuse Management

From: Hashita Khatnani

Subject: Winfield Refuse Management

Date: November 17, 2018

DON’T:

1. Make the memo out to me. You have a role in the case, and I don’t.

2. Be casual in your writing. A memo doesn’t require a salutation (Dear Mr./Ms. <last name>) but it cannot open with <first name> as if this were an email to your buddy.

3. Rehash basic case facts, such as the background of the company, industry or competitors. Your boss (the person to whom you are writing the memo) already knows them and you have precious little space on that one page to waste on informing them of what they already know. Only state things that are necessary to support your analysis and conclusion.

4. Copy and paste from Excel a bunch of numbers without headings or ways to know what are subtotals and think you’ve given me “exhibits”.  (Hint: hide gridlines before finalizing your exhibits). You don’t need your exhibits to look as polished as what you see in the Harvard or Ivey case studies (though I will give extra credit if they do), but as a minimum they should have a clear purpose, title, headings, subtotals (if needed), definitions (if needed, particularly for ratios), and a professional look to them. If your boss just wanted the Excel file, he/she would just ask for it.

5. Create Word tables that take up a good portion of a page and are mostly blank space. They give the appearance that you don’t care about what you show your boss.

6. Criticize or otherwise use negative or positive adjectives to pass judgment on operations or results of operations. Even the most experienced among you hasn’t worked a day in the business of that client (who might also be your boss, or your lending institution’s client), and you’d be embarrassed or get fired or both, if you said to their face their business decisions were “unwise,” “poorly run,” or any other adjectives you have used in your case memos so far. It’s hard to win back clients after you insult them. Even if your memo is internal to your boss at a bank, it’s discoverable and you don’t want your client getting wind of your criticisms – particularly as they are not necessary to complete your work. (Try it: go back and cut out the adjectives and re-read your memos. For the most part, you’ll find the adjectives did not affect your conclusion, only the analysis did.)

DO:

1. Use spell-check with the grammar option enabled.

2. Make your point early and then back it up with your analysis, and reiterate your conclusion at the end.

3. Only summarize in the memo the results you present in your exhibits as the support for your analysis, instead of restating in the memo a series of results that can easily be found in the exhibits.

4. Make brief and concise (i.e., to-the-point) assessments of the merits of the case using whatever analytical framework you are asked to apply. For example, “leverage decreased from <high #> in 20## to <low #> in 20##, which <supports the proposed expansion financing>”, rather than (the DON’T): “their leverage ratios are good” (what do you mean “they’re good”? how does your boss make sense of that?)

5. Make exhibits that are self-contained: no additional information should be needed to understand each one. Therefore, the title of each exhibit indicates its purpose. Any figures, whether dollars or ratios, are clearly identified including the relevant accounting dates or periods. Any amounts adding to a total or subtotal are presented so that the relationships are clear.

6. For any ratios where the underlying values were not already in the case (e.g., ratios based on pro-forma amounts you had to estimate before the ratio analysis), present BOTH the underlying values and the resulting ratios in your exhibits. Otherwise, I will take off points by marking “where did you get this #?”

7. Remember, there is no reasonable limit to the number or level of detail you include in exhibits, so make sure they are clear and include all that is necessary to use them and to understand your conclusion and analyses, even if you need additional pages for exhibits.

 
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