1

FI410 CORPORATE FINANCE

CASE: BARNES & NOBLE AND BN.COM


PROJECT DUE DATE: JAN 8TH, 2022

This project illustrates some important points we have covered in class, especially the challenge of accurately
estimating the value of a project for a firm (capital budgeting). The project is loosely based on Barnes &
Noble and BN.com. Many of the financial projections are actual numbers from BN.com financial statements.
However, additional assumptions and information have been provided for the sake of the exercise. 1
The challenge in this project is that many numbers have to be estimated, many decisions will be judgment
calls, and you will have to make many additional assumptions. That is not because the project is badly written
– it is simply unavoidable in real-world capital budgeting problems. The high degree of ambiguity will offer
scope for a lively class discussion, but it will also make it hard to grade the cases. I will therefore focus on
the quality and completeness of your arguments why you did things in a certain way, and not whether you
“missed” my own numbers by 10% or 2,000%. It is essential that you identify and sketch alternative ways
to overcome an obstacle if there are different alternatives, and that you carefully justify why your choice is
the most appropriate one among these alternatives. Just getting “close” to my solution by guessing or using
whatever method came to your mind first is not satisfactory. Of course, I will also focus on whether you
applied the formulas and techniques correctly, given your assumptions and decisions.


BACKGROUND

Barnes & Noble, incorporated in 1986, went public in 1993. By 1997, Barnes & Noble had become the
world’s largest bookseller and was in the midst of a very successful year. Sales hit an all-time high in 1997 of
$2.797 billion dollars, a 14% increase over 1996, and by April 1998, Barnes & Noble would join the Fortune
500. Furthermore, during 1997 their stock price increased 104%.
In September of 1996, Barnes & Noble opened a new central distribution center that had increased their
distribution network capacity five-fold. Barnes & Noble was a “bricks and mortar” bookseller and by the
end of 1997 it was operating 483 Barnes & Noble Superstores as well as 528 B. Dalton stores in 49 states
and the District of Columbia. In addition to books, Barnes & Noble was selling music, software, video and
video games.
In July 1995, Jeffrey P. Bezos founded Amazon.com and opened its virtual bookselling store for business.
Amazon.com went public during 1997 and by the end of 1997 had revenues just shy of $148 million dollars.
Bezos saw the Internet as a perfect medium for selling the very products Barnes & Noble specialized in:
books, music, video, software, etc. While the sales of Amazon.com were a far cry from the sales of Barnes
& Noble stores, Barnes & Noble company management recognized “the power of the Internet” and was
considering a move from a purely “bricks and mortar” bookseller to the new business paradigm of “bricks
and clicks”.
Industry studies indicated that the prospects for Internet commerce in the book industry were quite
favorable. International Data Corporation estimated that there would be 315 million Web users worldwide
by 2002 and other independent media research companies were estimating that 60% of online users would
be online shoppers. Forrester Research estimated that by 2002, the online sales of books, music, software
and video would total $8.4 billion dollars.

1 BN.com became a joint venture between Barnes & Noble, Inc. and Bertelsmann AG in October 1998. This company went
public in May 1999. In your frame of reference (1997), these are future events that you do not anticipate.
2

In 1997, Barnes & Noble discussed how to analyze the investment it would take to launch its own virtual
bookstore. The new website would respond to fledgling Amazon, which already had a two-year head start
as an Internet bookseller, and Borders which was also prepared to launch a web site in 1997.


PLANNING BN.COM IN 1997

In 1997, Barnes & Noble viewed the creation of BN.com as a complimentary business. Barnes & Noble was
already quite familiar with the bookselling business and management saw going online as an opportunity to
leverage both its extremely strong brand recognition as well as its new distribution center. Barnes & Noble
also viewed its retail outlets as viable partners for BN.com, given customers could potentially pick-up or
return orders through a local Barnes & Noble store. This would further enhance BN.com’s ability to provide
superior customer service.
Barnes & Noble’s strategy was to create a wholly owned subsidiary, BN.com, to be its online bookseller.
Management felt BN.com could capitalize on the Barnes & Noble name and its state of the art distribution
center that housed close to 750,000 different book titles. This would also provide Barnes & Noble with the
opportunity to take advantage of any losses incurred in the start-up phase of BN.com in its consolidated
corporate tax returns.
Management’s strategy was to build a robust web site with strong functionality and then enhance the user
experience by providing multiple search alternatives, reader reviews, online author chats, etc. Additionally,
BN.com would offer a huge selection, immediate delivery and a continually expanding product line.
Management expected significant expenditures on an ongoing basis to keep up with the latest technology.
From a marketing perspective, BN.com anticipated cross marketing and advertising with Barnes & Noble
retail stores as well as entering into strategic relationships with Internet service providers such as AOL,
Microsoft and Lycos. These relationships would require heavy capital requirements in the form of annual
payments to the providers as well as revenue sharing agreements. While such an investment would be
significant, it would also put BN.com in front of millions of regular Internet users.
Barnes & Noble and BN.com planned to enter into a number of formalized agreements for Barnes & Noble
to provide supply and distribution services, trademark licensing, database and software sharing and
management and administrative services.


FINANCIAL ESTIMATES IN 1997

Barnes & Noble expected BN.com to be in existence for a long time to come, with significant volatility and
heavy capital expenditures through its first five years, then significant growth through the next five years
and a steady growth after that. The pattern of projected revenues and expenses is provided in Table 1 below.
The first year sales are projected to be $12 million dollars. Initial investment (as of year 1) in Net Working
Capital is estimated to be $3 million dollars.

The corporate tax rate is 25% and the cost of capital for this project is 10%. After year ten, the Free Cash
Flow from the project is expected to grow at a constant rate g of 4% per year for the indefinite future. In
addition, all capital expenditures are assumed to be 5-year MACRS property for depreciation purposes. The
company uses MACRS for both book and tax depreciation.2


Table 1: Projections for BN.com

2 There is no period 0 investment. We assume that capital expenditures take place during each year. Moreover, all of the projections
in Table 1 reflect financial accounting practices for recognizing revenues and expenses.
3


Year 1 2 3 4 5 6 7 8 9 10
Sales growth rate 420% 215% 65% 60% 60% 40% 35% 20% 10%
Cost of Sales as a % of sales 85% 77% 83% 82% 76% 72% 70% 68% 68% 68%
Marketing and sales as a % of sales 74% 114% 52% 42% 33% 25% 21% 16.5% 14% 12.5%
Product development as a % of sales 25% 12.5% 10% 10% 7.5% 5% 4% 3.5% 3% 3%
G&A as a % of sales 9% 20% 10% 13% 12% 8% 6% 5% 4.5% 4.5%
Capital expenditure as a % of sales 150% 50% 37% 33% 20% 10% 8% 6% 5% 4%
% change in NWC 3% 3% 2% 1% -1% -3% -5% 0% 0%


ANALYTIC ISSUES IN DISPUTE

There is a fair amount of disagreement between various members of the team analyzing the feasibility and
the profitability of this project. Some of the key points involve:


THE DISTRIBUTION FACILITY

The new Barnes & Noble distribution facility has increased their capacity five-fold. Consequently, there is a
significant amount of excess capacity at the facility. Barnes & Noble had just finished a strong year with 14%
overall sales growth. Some members of the team felt that, even at this rate of growth, it would take a long
time to use up the excess capacity. Since the facility was already built, a good part of the argument centered
on how much of the facility and the associated expenses should be charged to the financial analysis of the
project, if any.

The head of the production team felt that the analysis should allow BN.com to use the space free of
charge. He reasoned that the costs should be considered sunk costs and should be removed from the project
analysis because the facility was already built. Moreover, due to the highly specialized nature of the space
and the systems supporting the space, it was unlikely that the company could lease any of the excess space.
However, he admitted that while the systems and space were in place, personnel expenses such as hiring
workers for the operation would eventually increase. Given the sales projections, he estimated the following
additional personnel expenses (incremental costs, not to be viewed as cumulative) if the facility is used by
BN.com.

Table 2

Year 1 $0
Year 2 $0
Year 3 $500,000
Year 4 $650,000
Year 5 $875,000
Year 6 $1,100,000
Year 7 $1,112,000
Year 8 $1,350,000
Year 9 $1,425,000
Year 10 $1,500,000
4


The head of the accounting department, agreed that for project valuation purposes, the costs associated with
the facility should be excluded. However, she felt that for financial statement purposes, in order to fully
burden the financial statements of BN.com, a charge for the use of the facilities ought to be included in the
Cost of Sales. This charge had two components:3
1. A market value rental fee for the facility equal to $240,000 in year 1. The fee was estimated to grow
at the Sales growth rate in the subsequent years.
2. An accounting charge equal to 1% of Sales. This accounting charge included all personnel and other
expenses, including the incremental staff needs outlined in Table 2 above, as well as a 10% surcharge
on these expenses. This charge ought to emphasize the goal of “fully burdening the BN.com financial
statements” set by the head of accounting department.
Other members of the team have stated that the financial analysis ought to include the market rental fee as
well as the incremental costs of additional personnel, but not the accounting allocation used for financial
statement purposes.


SALES EROSION FROM INTERNET SALES

There were also disagreements regarding the impact of BN.com on Barnes & Noble in-store retail sales.
Some team members maintained that the creation of BN.com was not, in and of itself, a factor in slowing
the growth of in-store retail sales. They maintained that Internet sales in general would eat into store retail
sales, be it BN.com, Amazon.com or some other Internet company. Therefore, it was unfair to burden the
project with a “cannibalization” factor. Sales management maintained that it would be sufficient if the overall
Barnes & Noble forecasts took the impact of Internet sales into account, because the financial forecasts
would then be accurate when looking at the two entities together. The Controller supported this point of
view because she viewed the projections as a financial accounting document. Net sales should represent just
that, net sales. Otherwise, profits would be understated (and losses overstated).
A second group was convinced that in order to look at the new Internet project on an incremental basis,
the erosion of in-store retail sales should be charged against the project. While the sale of books and related
products over the Internet was a minute percentage of the current overall market share, it was growing
rapidly. There were only three major players, and a handful of smaller bookstores, ready to sell over the
Internet. As previously stated, Amazon.com had opened its website for business two years previously and
Borders.com was running a parallel path with Barnes & Noble. Consequently, BN.com would be entering
this new arena. In addition, it was generally held that the Barnes & Noble customers were considered more
highly educated than the general populace and much more likely to own and use a personal computer. The
Barnes & Noble customer profile was the exact match of an Internet shopper. Given this, plus the ease of
selling the kinds of products Barnes & Noble sold over the Internet, erosion of in-store sales was inevitable
and should be viewed as a cost of the project. While gaining new customers would partially offset those who
would now buy at BN.com instead of going to a Barnes & Noble store, this second group of the team
analyzing the project was estimating that a minimum of 3% per year of the BN.com Sales should be offset
for erosion.
Finally, a third group argued that this discussion, as well as the one regarding the distribution facility, was
really pointless. They viewed Barnes & Noble’s Internet initiative as both a strategic and a competitive
reaction. Since the move was really meant to respond to competitive pressures from Amazon.com and other
Internet retailers, it did not really matter what the numbers said: approval of the project was a foregone
conclusion. Even if the project turned out to be unprofitable, as long as Barnes & Noble’s corporate stores
were able to absorb these losses, the project would be undertaken in order to avoid the risk of losing even a
larger amount of market share to the new Internet retailers.

3 Refer to the additional handout for more detailed explanation and examples about the charges.
5



ALLOCATION OF CORPORATE OVERHEAD

The final item that was up for discussion was the allocation of corporate overhead. Barnes & Noble has
always viewed its operating departments as profit centers. For any use of administrative services, such as
payroll, accounting, executive management and so on, the headquarters charged the subsidiaries and other
operating divisions at cost plus 10%.
In fact, the financial statement projections (Table 1) produced by the accounting department included
such allocations. According to financial accounting rules, 60% of the administrative expenses in the current
financial projections represented such cost allocation (including the charges from the administrative cost
plus the 10% surcharge). The accounting department viewed this new venture as no different from any other
operating division within Barnes & Nobel. Hence, they believed that it should be treated accordingly.
Others disagreed with the accounting department. They argued that Administrative Expenses were largely
fixed costs and that there would be no need to add additional fixed overhead until year 4 of the project. At
that time, it would be necessary to add about $500,000 in costs for management personnel. That annual
amount would suffice for years 4-6. Furthermore, longer-term projections indicated that in year 7 another
$750,000 in expenses would need to be added, totaling $1,250,000 for years 7-10. This amount would then
be sufficient for the foreseeable future.


YOUR JOB

Assume that your frame of reference is 1997 and that you are doing a comprehensive analysis for BN.com
as a capital budgeting project. You have absolutely no knowledge of events taking place after 1997.
1. Based on all the information provided above, determine the net income for the 10-year period for
BN.com. Do this by creating a pro-forma income statement for the projected period based on the
forecasts you have been given.
2. Make a decision on the treatment of each of the three areas in question, namely: The Distribution
Facility, Sales Erosion from Internet Sales, and Allocation of Corporate Overhead. State your position
explicitly. Carefully explain why you believe that your treatment of each of the three issues is correct.
3. Calculate the free cash flows generated by the project. In other words, you should adjust your
accounting net income to arrive at FCF in a table separate from the income statement. In your
calculation, you should take into account all the information provided as well as your decisions
regarding the three open issues. Calculate the NPV of the project.4
4. Barnes & Noble are concerned that they have been overly optimistic in estimating their Cost of Sales
numbers. Analyze the impact on the project if BN.com is unable to lower its Cost of Sales below 70%
of Sales? Show in a data table and a graph how sensitive the NPV of the project is with respect to the
Cost of Sales percentage.
5. Assuming that the cost structure is correct and given your other assumptions, analyze how the forecast
of the constant growth rate g affects your estimate of the NPV of the project. Use data tables and
graphs. Find the constant growth rate of free cash flows that sets the NPV to zero.




4 Since the project is a perpetuity with different growth rates, you will need to value the first 10 years of FCF as we have done in
class. For the remaining years, you should take the final year’s free cash flow (year 10 here), grow it for another year and divide it
by the Cost of Capital less the assumed growth rate to determine the continuation value of the project. In other words, [FCF11/(r-
g), where FCF11=FCF10(1+g)]. This will be the present value (as of year 10) of all the FCFs from year 11 through infinity.
6

ABOUT YOUR WRITE-UP

Your paper for this project should be 3 to 5 pages long. You should try to keep it as brief as possible and
focus on your analysis. Make sure that you explain carefully and in detail all decisions and assumptions you
make. In other words, your paper should explicitly discuss the decisions you made as well as how you arrived
at the final valuation. There is no need to re-hash the background information already presented in the case.
When writing up your solution, remember this: I will not “read between the lines” or realize that something
that you did not write down was “obvious” (that is why you need to justify your decisions in writing).
However, I know what a Discount Cash Flow model is, for example. In addition to the 3 to 5 pages of text,
you may add up to 3 pages of exhibits and also an Excel formula sheet. You should print this to expose the
column and row headings (letters and numbers in Excel). Failure to do so would lead to a significant penalty
on your score.





































7

FI410 CORPORATE FINANCE

PROJECT 1

BARNES & NOBLE AND BN.COM


PROJECT DUE DATE: JAN, 8TH

ADDITIONAL EXPLANATIONS

THE DISTRIBUTION FACILITY

Table 1 is prepared by the Accounting Department of Barnes & Nobel. When constructing your pro-forma
Income Statement and deriving the FCF, you should recognize that the Cost of Sales for each year includes
two types of charges. It includes a rental fee charge for the use of the facility: $240,000 for year 1, growing
at the Sales growth rate each year after that. It also includes a charge that amounts to 1% of Sales. This 1%
charge includes the allocation of all personnel and other expenses (including the incremental staff needs
outlined in Table 2) as well as a 10% surcharge on these expenses.
For example, take year 3. Sales are $196.56m ($12m×(1+420%)×(1+215%)). From Table 1, the Cost of
Sales is 83%×$196.56m = $163.14m. This amount includes the rental fee charge for the facility in year 3 of
$3.93m (=$240,000×(1+420%)×(1+215%)). Furthermore, the $163.14m Cost of Sales also includes 1.97m
(1%×$196.56m) worth of personnel and other expenses + the 10% surcharge on these expenses. Being part
of the overall personnel expenses, the incremental personnel needs in Year 3 of $500,000 (see Table 2) along
with a surcharge of $500,000×10% are included in the 1.97m charge.

ALLOCATION OF CORPORATE OVERHEAD

Barnes & Noble owns several subsidiaries and the headquarters provide administrative services such as
payroll, accounting, etc. to the subsidiaries. As a result, the headquarters allocate these expenses among the
subsidiaries and also charge 10% surcharge of these expenses. The G&A expense in Table 1 reflects such
an allocation. For example, take year 1. Sales are $12 million which implies that G&A expenses are $1.08m
(=$12m×9%). The project states that 60% of the $1.08m (which is $0.65m) represents corporate overhead
allocation. This allocation includes both the administrative cost and the 10% surcharge.