Team Paris: Waldo County

Kirk Baringer
Danielle Gooch
Summer Leifer
Brett Wanner
Southwestern College
Joel Light, Ph. D.
MGMT 565 Financial Analysis and Management
March 25, 2012

Waldo County 1
Waldo County Real Estate Developers
Waldo County has well been known as one of the best real estate developers in the
United States. The owner and founder, Mr. County, has become successful at real estate
developments due to his keen nose for picking the perfect site for development. However, Mr.
County has never been great at the financial aspect of real estate development projects. This is
where George Chavez comes in.
Mr. Chavez has been tasked with providing a presentation on a proposed real estate
development project. In the eyes of Mr. County, location is the most important factor in success
of any real estate project. Though location is an important part of the formula for success, Mr.
Chavez needs to fully analyze all aspects of the real estate project from construction to the
projected retail sales following the grand opening.
Proposed Outlet Mall
The proposed real estate development project is for a $90 million outlet mall. Outlet
malls are the fastest-growing segment of the American retail market and saw a $3.6 million
growth in sales from 1990-1994 (Vinocur, 1994). This growth could be in response to increasing
consumer demands for good deals which normally cannot be found at regular retail stores
(Chapman, 2003). In fact, total sales per square foot outperform that of these same retail malls.
This has helped attract very popular merchandisers who are very interested in the factory outlet
mall concept.
The potential success of the proposed outlet mall rests in part to its location which is
intended to draw in tourists heading down east toward Maine (Brealey, Myers, & Allen, 2011).
Most outlet malls are built right off major freeways and near major cities (Vinocur, 1994). They
are also springing up near popular tourist locations which helps bring in more earning potential.

Waldo County 2
The main reason why outlet malls are built in these types of locations has to do with the
merchandisers themselves. The merchandisers want to protect their full-price stores and do not
want these outlet malls to directly compete for the same consumer dollars (Chapman, 2003).
Typical outlet malls run between 100,000 and 200,000 square feet when they initially
open, but they often expand to accommodate the high demands of both the consumer and
merchandiser. The problem facing the proposed outlet mall is making sure as much of that
square footage is rented prior to opening. In the past, outlet malls have required stores to sign
month-to-month or even 90-day leases (Vinocur, 1994). Now it is common for stores to sign a
seven to ten-year lease which is still shorter a lease than required by regular retail malls
(Vinocur, 1994). These leases are important, because most lenders require outlet malls to have
70 percent of their spaces rented prior to loaning any development funds (Vinocur, 1994). So,
location is not the only factor that must be considered in measuring the potential success of the
proposed outlet mall.
Essential Financial Information
The initial investment for the proposed outlet mall includes $30 million for the land and a
total of $60 million dollars for construction spread over three years. The three year construction
schedule will produce a structure which will surpass the highest building specifications and
would not need to be rebuilt until 17 years after it is finished. The investment in the land is
expected to retain its value and will not be depreciated for tax purposes (Brealey, Myers, &
Allen, 2011). However, construction costs will be depreciated straight-line over 15 years starting
at year number three (Brealey, Myers, & Allen, 2011).
The proposed outlet mall will have two sources of income. The company would charge
an annual rent for its retail space. In addition to rent the proposed outlet mall would receive five

Waldo County 3
percent of each stores gross sales (Brealey, Myers, & Allen, 2011). Figure 1 provides the
projected revenues and costs in real terms for the proposed outlet mall (Brealey, Myers, & Allen,
2011).
Some pieces of financial information that must be included in any financial analysis are
the expected rates of inflation, tax rate, and the current companys cost of capital. Construction
costs, revenues, operating and maintenance costs, and real estate taxes are all due to increase by
two percent a year due to inflation (Brealey, Myers, & Allen, 2011). Mr. Chavez has wondered
what a 10 percent rate of inflation would affect the numbers used in the financial analysis of the
proposed outlet mall. The companys current tax rate is 35 percent tax rate, and their cost of
capital is nine percent.
Figure 1: Projected revenues and costs for proposed outlet malls ($ millions)

Year
0

5-17

30

10

Rentals

12

12

12

Share of retail sales

24

24

24

Investment:
Land

30

Construction

20

Operations:

Operating and maintenance costs

10

10

10

Real estate taxes

Previous projects operated by Waldo County have not been as successful as first planned.
The Salome project saw sales 40 percent below original forecasts, and other projects saw
construction cost overruns of 25 percent with a 12-month delay in construction. It was
mentioned earlier that Mr. County was not strong at analyzing things financially. All the

Waldo County 4
information included in this section as well as past projects financial information must be
considered in any calculations and analysis.
Essential Financial Analysis
The value of any proposed project is based on its earning potential. Any financial
analysis must compare the expected revenues over the expected life of the project relative to the
size of the investment (Bleck, 1973). This analysis must also involve projecting cash flows and
expenses over the expected life of the project (Bleck, 1973). The traditional method that can be
used in such an analysis is the calculated rate of return which is calculated by dividing the cash
flows by the costs of acquiring those cash flows (Bleck, 1973). However, this method does not
account for the year-to-year variation of either the cash flows or expenses (Bleck, 1973).
There is only one method which can overcome the disadvantages of the traditional rate of
return method, and this is the Internal Rate of Return (IRR). The IRR method can account for
variations in construction costs, rental schedules, and sale forecasts. All three of these variations
can have a huge impact on the projected cash flows and financial numbers associated with the
proposed outlet mall. Two IRR calculations were conducted for the financial analysis of the
proposed outlet mall. The first IRR was calculated at 23 percent and was based on the figures
provided in Figure 1. These numbers are all based on an on-time completion of construction and
maximal rental capacity. If the construction produced a 25 percent cost overrun and a 12-month
delay the IRR would then be calculated at 19 percent. The drop in percentage was mainly due to
the lack of rental income due to the construction delays. If retail space is not rented the outlet
mall will lose that potential earning capability.
Along with calculating the IRR and years until the initial investment is paid back,
managers benefit greatly from seeing how Net Present Value (NPV) is affected by certain

Waldo County 5
different scenarios. Initially, they use expected metrics/figures to calculate NPV. This equation
is expressed in its simplest form as:
Present Value (PV)=C0+(C1/(1+r)^t)
In the case of Waldo County and potential investment in an outlet mall the NPV for the
initial 17 years is expressed in the following way. The calculations used expected cash flows in
millions of dollars and a discount rate of nine percent:
-54+(-36/(1.09)) +(-17/(1.09)^2) +(22/(1.09)^3) +(22/(1.09)^4) +(22/(1.09)^5) +(22/(1.09)^6)
+(22/(1.09)^7) +(22/(1.09)^8) +(22/(1.09)^9) +(22/(1.09)^10) +(22/(1.09)^11) +(22/(1.09)^12)
+(22/(1.09)^13) +(22/(1.09)^14) +(22/(1.09)^15) +(22/(1.09)^16) +(22/(1.09)^17) = 47.923361
The NPV of the proposed outlet mall in the first 17 years is $47,923,361. The NPV here
shows that on top of the discount rate of nine percent the investment in the mall would generate
an excess of $47 million. Any manager would say go for it right? Well that depends on the
industry, the sensitivity of the project, and the expected rate of return. This would bring any
manager to the inevitable next stage of inquiry, sensitivity, and scenario analysis.
Risk vs. Reward
A sensitivity analysis is an analysis of the effect on project profitability of possible
changes in sales, cost, and so on (Brealey, Myers, & Allen, 2011). Using this process gives
managers an idea of how vulnerable their potential project is to market conditions. This is
important if a projects profits are easily turned negative by a small cost overrun, or a 5 percent
difference in sales than expected. It may be abandoned for something more robust. In a
sensitivity analysis a company goes over the projections they have for all viable metrics and puts
together a pessimistic projection along with an expected and optimistic projection. These three
are then usually displayed in a manner that lends them being easily compared side by side. For
the proposed outlet mall we chose projections plus and minus 40 percent of sales. We will

Waldo County 6
explain our reasoning behind this later on. The following is the sensitivity analysis for the
proposed outlet mall.
Pessimistic Calculation = -54+(-36/(1.09)) + (-17/(1.09)^2) + (12.4/(1.09)^3) + (12.4/(1.09)^4)
+ (12.4/(1.09)^5) + (12.4/(1.09)^6) + (12.4/(1.09)^7) + (12.4/(1.09)^8) + (12.4/(1.09)^9) +
(12.4/(1.09)^10) + (12.4/(1.09)^11) + (12.4/(1.09)^12) + (12.4/(1.09)^13) + (12.4/(1.09)^14) +
(12.4/(1.09)^15) + (12.4/(1.09)^16) + (12.4/(1.09)^17) = -17.2080325
Expected Calculation =-54+(-36/(1.09)) + (-17/(1.09)^2) + (22/(1.09)^3) + (22/(1.09)^4) +
(22/(1.09)^5) + (22/(1.09)^6) + (22/(1.09)^7) + (22/(1.09)^8) + (22/(1.09)^9) + (22/(1.09)^10) +
(22/(1.09)^11) + (22/(1.09)^12) + (22/(1.09)^13) + (22/(1.09)^14) + (22/(1.09)^15) +
(22/(1.09)^16) + (22/(1.09)^17) = 47.923361
Optimistic Calculation =-54+(-36/(1.09)) + (-17/(1.09)^2) + (31.6/(1.09)^3) + (31.6/(1.09)^4) +
(31.6/(1.09)^5) + (31.6/(1.09)^6) + (31.6/(1.09)^7) + (31.6/(1.09)^8) + (31.6/(1.09)^9) +
(31.6/(1.09)^10) + (31.6/(1.09)^11) + (31.6/(1.09)^12) + (31.6/(1.09)^13) + (31.6/(1.09)^14) +
(31.6/(1.09)^15) + (31.6/(1.09)^16) + (31.6/(1.09)^17) = 113.0547549

As you can see the pessimistic swing has prices going into the negative for NPV. How
likely are sales going to be 60 percent of what is expected? Who really knows? This would be a
problem needing further analysis, but our research speaks of a similar mall that experienced 60
percent of expected sales and was a total loss. Using these types of worst case and best case
analysis, managers can get a sense of how sensitive their potential project is to potential shifts in
the market.
Another way a manager can get an idea of how a projects profitability reacts to change is
by applying certain scenarios to the given project and examining how this will affect the NPV.
Rightly enough this method is called scenario analysis. There are three specific scenarios that
Waldo County would like addressed by Monday morning. They are the possibility that the sales
forecast is inflated (Salome project scenario of 60 percent of projected sales and percentage of
projected sales to break even), inflations effect on cash flows (10 percent inflation), and lastly

Waldo County 7
the effect of construction delays and cost overruns (12 month delay/25 percent construction cost
overrun) (Brealey, Myers, & Allen, 2011).
To address the sales forecast scenarios we must first address the scenario where sales are
60 percent of what was forecasted. This is why we chose to use a +/- 40 percent in our
sensitivity analysis earlier. The NPV of the proposed outlet mall project, if sales were 60 percent
of projected, would be more than 17 million in the negative. The second piece that must be
addressed is at what levels sales must be maintained to keep the projects from going
underwater. In other words how low can the percentage of projected sales go before the
projects NPV becomes a negative? The following chart illustrates this idea perfectly.
Figure 2: NPV vs. Sales Forecast

NPV (in millions) vs. Sales Forecast

(as percentage of expected)

$150.00
$100.00
$50.00

NPV

$60%

100%

140%

$(50.00)
As you can see from the data on the graph the NPV becomes a negative if sales drop
below approximately 70 percent of the forecasted amount. To project inflation on cash flows for
the 17 years the projects NPV annual interest rate of 10 percent must be applied to each cash
flow past year one. The following is a list of cash flow equations for year 1-17:

Waldo County 8
Year 0= -54
Year 1= (-36/(1.09))
Year 2= (-17(1.1)^2/(1.09)^2)
Year 3= (22(1.1)^3/(1.09)^3)
Year 4= (22(1.1)^4/(1.09)^4)
Year 5= (22(1.1)^5/(1.09)^5)
Year 6= (22(1.1)^6/(1.09)^6)
Year 7= (22(1.1)^7/(1.09)^7)
Year 8= (22(1.1)^8/(1.09)^8)
Year 9= (22(1.1)^9/(1.09)^9)
Year 10= (22(1.1)^10/(1.09)^10)
Year 11= (22(1.1)^11/(1.09)^11)
Year 12= (22(1.1)^12/(1.09)^12)
Year 13= (22(1.1)^13/(1.09)^13)
Year 14= (22(1.1)^14/(1.09)^14)
Year 15= (22(1.1)^15/(1.09)^15)
Year 16= (22(1.1)^16/(1.09)^16)
Year 17= (22(1.1)^17/(1.09)^17)
Lastly, the scenario that Waldo County had addressed concerning construction delays and
cost overruns must be examined. It is clear the delays mean that the mall cannot generate
revenue from rent and sales for an additional 12 months after the project is initiated. Cost
overruns of 25 percent will also raise the cost for the initial years. Both of these would clearly
have a negative effect on NPV, but how negative? The only way to find out is by applying these
new values to the equation for NPV and examining the result.

-30+(-29/(1.09)) +(-42.5/(1.09)^2) +(-19.5/(1.09)^3) +(28/(1.09)^4) +(22/(1.09)^5)

+(22/(1.09)^6) +(22/(1.09)^7) +(22/(1.09)^8) +(22/(1.09)^9) +(22/(1.09)^10)
+(22/(1.09)^11) +(22/(1.09)^12) +(22/(1.09)^13) +(22/(1.09)^14) +(22/(1.09)^15)
+(22/(1.09)^16) +(22/(1.09)^17)= $29,087,476
47.923361-29.087476=18.835885 or $18,835,885

In this case a 12 month delay and cost overrun of 25 percent costs the project nearly 19
million dollars in NPV. That being said, the project would still have a positive NPV in excess of
29 million dollars.

Waldo County 9
Potential Options for Review
Waldo County Construction has two options in regards to the proposed project to build an
outlet mall. Mr. Countys first option is to build an outlet mall in an area heavily travelled by
tourists heading southeast towards Maine. Many companies utilize outlet stores and malls to
move merchandise that failed to sell previously in regular retail stores (Cohen, 2005).
Additionally, while the U.S. retail markets may have suffered setbacks due to the lagging
economy, outlet malls are actually on the upswing. According to NDP Group, a market research
firm, from April 2010 to April 2011, factory outlet apparel sales rose 17.8 percent compared to
1.4 percent apparel sales industry wide (Chang, 2011). The second available option is to choose
not to invest in this project at this time. Although, outlet malls are currently doing well in U.S.
markets, Waldo County Construction has suffered setbacks in the past with a similar project, the
Salome project, which failed to bring in forecasted retail sales. Additionally, inflation rates may
have a dramatic increase. Finally, the proposed project may suffer cost overruns and delays
adding to the companys cost burden.
Recommendations
Based on each options projected losses and gains we recommend Waldo County
Construction pursue this project. As Andrew Roud of BAA McArthurGlen, a designer outlet
company, explained, Factory outlets are not standard shopping centers, they are for impulse
shoppers, places which day-trippers can include on their itinerary. Factory outlets complement
local retailers, and they have a wide catchment area" (Cohen, 2005). Additionally, outlet malls
offer retail companies to move products without fear of cannibalizing their own customers
(Chang, 2011). Gochelle Simpson, Vice-President for finance for Tanget Factory Outlet Centers,
asserts, As long as the manufacturers are demanding, outlet developers will be building

Waldo County 10
(Kosnett, 1994). With such widespread support of outlet retail malls and a prime location,
Waldo County is sure to recoup its initial investment of $90 million and a handsome profit.
Finally, outlet mall construction is a far less risky investment than other current available
options.
Conclusion
Waldo County Construction learned valuable lessons from the Salome project
experience. The company learned to carefully analyze all available and pertinent data to include
potential inflation rate increases, construction costs overruns, and delays due to bureaucracy and
environmental issues. Currently, the company has two options available: pursue an outlet mall
construction project located on a heavily traveled tourist route or to pass up the project in favor
of investing in other construction projects. After carefully reviewing the data and running Monte
Carlo simulations, the best way for Waldo County Construction to make money is to pursue the
current proposed outlet mall project.

Waldo County 11
References
Bleck, E. K. (1973). Real Estate Investments and Rates of Return. Appraisal Journal, 41(4), 535.
Brealey, R. A., Myers, S. C., & Allen, F. (2011). Principles of Corporate Finance. New York:
McGraw-Hill/Irwin.
Chang, A. (2011, August 7). Outlet malls growing bigger, more popular. Los Angeles Times.
Retrieved from http://articles.latimes.com/2011/aug/07/business/la-fi-0807-cover-outletmalls-20110807
Chapman, P. (2003). Outlet Centers Thrive in Retail Sales Slump. Shopping Center World,
32(4), 18.
Cohen, N. (2000, May 05). Outlet centres appeal to aspirational shoppers: FACTORY
OUTLETS by norma cohen: While there are differing views about the impact of factory
outlets on small retailers, consumers are delighted. Financial Times, pp. 03-03. Retrieved
from http://ezproxy.sckans.edu/login?url=http://search.proquest.com/docview/
248872971?accountid=13979
Kosnett, J. (1994). An outlet store for every taste. Kiplinger's Personal Finance Magazine,
48(12), 14.
Strung, J. (1976). The Internal Rate of Return and the Reinvestment Presumptions. Appraisal
Journal, 44(1), 23.
Vinocur, B. (1994). The ground floor: Outlet malls: Build them and they will come. Barrons,
74(12), 52.