New Heritage Doll Company:: Capital Budgeting

Applied Corporate Finance
February 2015
New Heritage Doll

Company:
Capital Budgeting
Agenda
1. Executive Summary
2. Overview of New Heritage Doll Companys two project proposals
3. Projects Valuation NPV calculation
4. Comparison between Investment Rules - NPV, IRR and Payback Period
5. Missing information
6. Final recommendations
Applied Corporate Finance | Group 2A
New Heritage Doll Company

Problem Setting
The production
division one of three in the company had

two attractive project proposals
Due to financial restrictions, it was possible that only one of
them would be approved
Which project should Harris, the divisions VP, recommend to
the capital budgeting committee?

Two Project Proposals
Match My Doll Clothing Line Expansion (MMDC)
Expansion of an existing, successful line from one to all four seasons
of the year
Lines current popularity would allow premium prices
New products expected to be at least as profitable as the existing ones
Expected
off-peak
discounts
from
suppliers
and
contract
manufacturers
Expansion would maintain or even reduce seasonality in sales and
earnings
Relatively large upfront R&D and marketing expenses to take
advantage of the project as quickly as possible tax deductible
Harris considered the projects risk to be moderate discount rate of
8,4% (as defined by the company)

Design Your Own Doll (DYOD)
Targeted existing customers
Research showed many loyal customers would buy another doll if it was customizable
Potential to increase customer loyalty
As a custom product, it could carry a premium price
Manufacturing expense would increase
Due to low production volume, fixed cost per unit would be high, as would the BEP
Required large investments to adapt technology infrastructure and website, since process
would be carried out online
Involved a long development time (around 12 months)
R&D and marketing expenditures would be tax deductible
Required additional investments in equipment before 2014
Would use companys existing IT staff for development work during 2011 costs not
considered in initial outlays almost certainly available to work on the project
Projects risk included: long payback period; different manufacturing process; new
software; relationship with best customers; worked with companys strategy of creating a
unique experience for its customers

Comparing both projects:
High risk discount rate 9%

+ smaller potential to create
value
Based on this information alone, project MMDC appears to be more

compelling
Projects Valuation
NPV calculation
Free Cash Flows were calculated based on the forecasts available. FURTHER
ASSUMPTIONS:
Match My Doll Clothing
Discount
rate
Chosen
according to
the risk profile
of the project
Terminal
value
FCF growth
rate
Assumed to
correspond to
half of the
annual growth
projected in
2014-2020
8.4%
Medium-risk project:
extension of a successful line,
benefiting from its current
popularity
Design Your Own Doll
9.0
%
High-risk project:
High BEP volume (due to high
fixed costs)
Longer payback period
Dependent on the perfect
operation of new software and
user interfaces
Duration of the projects after 2020 are not known with certainty, but it is assumed to
create value indefinitely.
4.0%
Lower than the projected annual

growth in 2014-2020 (~8%)
3.0%
Lower than the projected

annual growth in 2014-2020
(~6%)
These rates are in line with the 3% growth in the sales of dolls in the US until 2013 and
respect the companys conservatism (they are lower than near-term growth forecasts). If
still they may seem too optimistic:
These are nominal rates and thus have the effect of inflation incorporated into
them: the real growth of FCF that is being assumed is actually lower.
These are average rates, therefore higher rates in the first years after 2020 may
compensate the slowdown in growth thereafter;
Corporate
Finance
| Group
2A from new emerging economies,
There mayApplied
be an increase
in external
demand
(namely
Projects Valuation
NPV calculation
Match My Doll Clothing Line Extension
(All values in $
thousands)
2010
2011
2012
2013
2014
2015
4 500
6 860
8 409
9 082
9 808
575
575
587
598
610
622
635
648
660
674
2 035
3 404
4 291
4 669
5 078
5 521
6 000
6 519
7 079
7 685
1 890
2 881
3 532
3 814
4 120
4 449
4 805
5 189
5 605
6 053
Selling, General &

Admin.
1 250
1 155
1 735
2 102
2 270
2 452
2 648
2 860
3 089
3 336
3 603
EBITDA
-1 250
735
1 146
1 430
1 544
1 668
1 801
1 945
2 100
2 269
2 450
152
152
152
152
164
178
192
207
224
242
Revenue
2016
2017
2018
2019
2020
Terminal
value
(2020)
10 593 11 440 12 355 13 344 14 411
Production Costs
Fixed Production
Expense
Variable Production
Costs
Gross Profit
Depreciation
EBIT (Operating
Profit)
-1 250
583
994
1 277
1 392
1 503
1 623
1 753
1 893
2 045
2 209
Income Tax at 40%
233
398
511
557
601
649
701
757
818
883
Unlevered Net Income -1 250
350
596
766
835
902
974
1 052
1 136
1 227
1 325
Depreciation
152
207
224
242
Applied
Finance
152 Corporate
152
152
164| Group
178 2A 192
Projects Valuation
NPV calculation
Design Your Own Doll
(All values in $
thousands)
2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Terminal
value
(2020)
14 360 20 222 21 435 22 721 24 084 25 529 27 061 28 685

Revenue
6 000
Production Costs
Fixed Production
Expense
Variable Production
Costs
1 650 1 683 1 717 1 751 1 786 1 822 1 858 1 895 1 933

11 427 12 182 12 983 13 833 14 736 15 694 16 712
2 250 7 651
10 040
2 100 5 026 7 078 7 502 7 952 8 430 8 935 9 471
1 240 2 922 4 044 4 287 4 544 4 817 5 106 5 412 5 737
Gross Profit
Selling, General & Admin.
0
0
1 201
-1 201
EBITDA
860
Depreciation
310
550
2 104 3 033 3 215 3 408 3 613 3 830 4 059 4 303

310
310
436
462
490
520
551
584
-1 201
EBIT (Operating Profit)
Income Tax at 40%
0
-1 201
1 794 2 724 2 779 2 946 3 123 3 310 3 509 3 719
220
718 1 089 1 112 1 178 1 249 1 324 1 403 1 488
10
Projects Valuation
The Match My Doll Clothing has an
Match My Doll
Clothing
(MMDC)
Design Your Own

Doll
(DYOD)
Discount
rate
8.4%
9.0%
FCF growth
rate
4.0%
3.0%
US$ 8 427 324.

21
US$ 6 878
750.81
NPV
Projects NPV
Depending on growth
rates
0,0%
0,5%
1,0%
1,5%
2,0%
2,5%
3,0%
3,5%
4,0%
MMDC
DYOD
3932
3185
4245
3619
4600
4108
5007
4662
5477
5296
6027
6026
6679
6879
7464
7886
8427
9095
higher NPV and therefore it creates

more value.
However, this result is
highly
tied
to the assumptions made,

namely:
- perpetual life of the projects;

growth rate after 2020.
Project that creates more Value
depending on growth rates chosen

MMDC/
DYOD
0,0%
0,5%
1,0%
1,5%
2,0%
0,0%
MMDC
MMDC
DYOD
DYOD
DYOD
0,5%
MMDC
MMDC
MMDC
DYOD
DYOD
1,0%
MMDC
MMDC
MMDC
DYOD
DYOD
1,5%
MMDC
MMDC
MMDC
MMDC
DYOD
2,0%
MMDC
MMDC
MMDC
MMDC
MMDC
2,5%
MMDC
MMDC
MMDC
MMDC
MMDC
3,0%
MMDC
MMDC
MMDC
MMDC
MMDC
3,5%
MMDC
MMDC
MMDC
MMDC
MMDC
4,0%
MMDC
MMDC
MMDC
MMDC
MMDC
2,5%
3,0%
3,5%
4,0%
DYOD
DYOD
DYOD
DYOD
DYOD
DYOD
DYOD
DYOD
DYOD
DYOD
DYOD
DYOD
DYOD
DYOD
DYOD
DYOD
DYOD
DYOD
DYOD
DYOD
MMDC
DYOD
DYOD
DYOD
MMDC
DYOD
DYOD
DYOD
MMDC
MMDC
DYOD
DYOD
MMDC
MMDC
MMDC
DYOD
11
Comparison between Investment Rules

NPV, IRR and Payback Period
Match My Doll
Clothing
(MMDC)
Discount
rate
Design Your
Own Doll
(DYOD)
8.4%
9.0%
NPV
US$ 8 427 324.

21
US$ 6 878
750.81
IRR
15.91%
13.02%
Payback
Period
8 years and 1
month
10 years and 4
months
Adjusted
Payback
Period
11 years and 9
months
17 years and 6
months
Note: The calculation of the months in the

normal and adjusted Payback Period was
made assuming that FCF are distributed
evenly throughout the year.
If Emily Harris evaluates both proposals as standalone projects, meaning that taking one project
does not constrain companys ability to undertake
other project, she would base her decision on the
NPV rule (accept project if NPV>0) and
recommend the two projects.
This
is consistent with the fact that both MMDC

and DYOD projects have IRRs higher than their cost
of capital, these being projects where the negative
FCF come in the first years and are followed by
positive FCF. Thus, in this case, the IRR rule could
be applied and would lead to the same
conclusions.
12

When investments decisions involve a stand-alone project, such decisions
can be taken based on NPV rule, IRR or payback period. However, both IRR and
payback period have their pitfalls.
The payback period rule ignores the cost of capital, the time value of money (the
reason why we also calculated the discounted PB) and also ignores the cash
flows after the payback period.
On the other hand, IRR rule does not apply when we have delayed investments,
non existent IRR and multiple IRRs. In these cases, IRR rule and NPV rule may
enter in conflict leading to different decisions- NPV rule prevails.
13

Match My Doll
Clothing
(MMDC)
Design Your
Own Doll
(DYOD)
8.4%
9.0%
NPV
US$ 8 427 324.

21
US$ 6 878
750.81
IRR
15.91%
13.02%
Payback
Period
8 years and 1
month
10 years and 4
months
Adjusted
Payback
Period
11 years and 9
months
17 years and 6
months
Discount
rate
Bearing in mind that Emily Harris must recommend only

one of the proposals, she should decide on the
project with the highest NPV, as this is the more
reliable and accurate tool. Thus, Harris shall expand
the Match My Doll Clothing line - NPV of 8 427
thousand dollars- since it creates more value to the
company.
This is also the project with lower payback periods.
Note: The calculation of the months in the

normal and adjusted Payback Period was
made assuming that FCF are distributed
evenly throughout the year.
14

When concerning to choose one project over the other, we are before what is called
as Mutually Exclusive Projects.
In these situations, one must select the
alternative with the highest NPV since the IRR rule may not apply here and the
Payback period ignores the FCF after the PB period. The IRR rule may lead to
mistakes and consequently to wrong decisions when projects have differences in
scale (which is the case), risk and timing of cash flows.
When direct comparison of IRRs is not possible, the incremental IRR can be
computed in order to make the alternatives comparable. However, one must be
aware that this rule has its shortcomings. Like in IRR rule, the incremental IRR may
not exist or multiples incremental IRRs can exist , an IRR higher than the cost of
capital does not imply a positive NPV and finally, when projects have different cost of
capital is unclear which one should be compared with the incremental IRR.
In the presented case, the individual projects have different cost of capital and
for this reason the incremental IRR can not lead to a reliable conclusion.
15
Missing Information
In order for Harris to complete her analysis and compare the
two projects she needs additional information that can be
obtained through these questions:
What are the long run growth prospects? How long are the projects
expected to last?
What is the impact of each project in the other business segments of
the company?
16
Missing Information
What are the long run growth prospects? How long are the
projects expected to last?
What is the impact of each project in the other business segments of
the company?
17
Missing Information
What are the long run growth prospects? How long are
the projects expected to last?
One of the most important components in capital budgeting is the Terminal

Value as it has a considerable impact in the projects NPV. As its possible to
observe, a small change in the long run growth rates can dramatically affect
the value of the project.
DYOD Project
G=2% => NPV=$5 296
K
MMDC Project
G=3% => NPV=$6 679
K
1%
1%
DYOD Project
G=3% => NPV=$6 879
K
MMDC Project
G=4% => NPV=$8 427
K
+
1%
+
1%
DYOD Project
G=4% => NPV= $9
095 K
MMDC Project
G=5% => NPV= $11
209 K
18
Missing Information
At the same time, it is important to know the estimation of the length

of the projects, as this factor could influence the decision. If we
decrease the length of both projects in order that MMDC has a
considerably lower life than DYOD, the NPV of the first one will
consequently be lower.
MMDC Project
T= => NPV=$ 8
427 K
DYOD Project
G= => NPV=$6
879 K
MMDC Project
T= 25 => NPV=$3
401 K
DYOD Project
G= 35 => NPV=$4
105 K
19
Missing Information
So, in order to have a complete and correct analysis of the

projects and to compare them we must have a clear
estimation of the projects length and of its cash flow growth
rate made by the projects sponsors.
Otherwise, if we blindly try to estimate those parameters we will

miscalculate the NPV.
As a consequence we could end up choosing the project with the

lowest associated value.
20
Missing Information
What are the long run growth prospects? How long are the projects
expected to last?
What is the impact of each project in the other business
segments of the company?
21
Missing Information
When we are estimating the incremental cash flows of a project we

should not only look to the cash flows generated by the project per se,
but also to the impact generated by the project in the cash flows of the
other business segments.
These externalities, when they exist, can be positive, as other products

could see a boost in their sales or a reduction in their production costs
due to the fact that we run the new project. On the other hand we can
generate negative externalities, as we can increase the production cost
of other goods or decrease their sales revenues cannibalization.
22
Missing Information
What
is the impact of each project in the other

business segments of the company?
The Match My Doll Clothing project could generate a boost in the sales
of the company dolls as more girls want to have their clothes equal to
the ones of their dolls. However, it is possible that it will cannibalize
the sales of other doll clothes.
The Design Your Own Doll project could reduce the revenue from the
sale of other dolls from the company, but it will most certainly increase
the revenue from doll clothes and accessories.
23
Missing Information
If we just look to the cash flows generated by the project per se, we
could end up choosing a project that on its own has a higher NPV, but in
reality has the lowest NPV due to cannibalization effects. On the other
hand, we can ignore a project that seems to have the lowest NPV, but in
reality has the highest one as it improves the revenue of other goods.
So, in order to have a complete and correct analysis of the

projects and to compare them we must have a clear estimation
of the projects impacts in the other business segments.
24
Overview & Final Recommendations

Taking all our assumptions as correct:
Harris should pick the project Match My Doll Clothing and Line Expansion
(MMDC)
MMDC is the project with the highest NPV, 8427 thousand dollars
Design Your Own Dool (DYOD) has an NPV of 6879 thousand dollars
WHY this decision?

The highest NPV will lead to the greatest increase in wealth, since
the NPV expresses the value of the project in terms of cash today
25
MMDC s IRR, 15,91% and DYODs IRR , 13,77%

Harris decision cannot be based in the comparison of the IRRs because the
two projects have different scales of investment and different risks

IRR
measures the average return of the investment,
solevels
it is a of
measure
Different
Risk that is
Different scales of Initial
not affected
by the scale of the investment Projects cost of capital is
Investment
determined by the projects risk
Ranking projects by their IRR ignores risk differences
MMDC lower investment
3520 thousand dollars
DYOD has a higher
investment
5811 thousand dollars
MMDC has a moderate risk

Lower discount rate = 8,4%
DYOD has high risk
Higher discount rate = 9%
26
The incremental IRR would be another way to compare the projects IRR, however in
this case it is not possible to calculate because the incremental cash flows change
in sign more than once
Either way the projects have different costs of capital, so it is not obvious what cost
of capital the incremental IRR should be compared to
Using the incremental IRR to make the decision would be difficult and could lead to
errors.
In this case its better to rely our decision on the NPV results, which allows
each project to be discounted at its own cost of capital, giving us the most reliable
choice.
We recognize that the results are sensitive to the set of assumptions made.
Information missing should be collected in order to confirm which project
should be undertaken.
27
Applied Corporate Finance

February 2015
New Heritage Doll

Company
Q&A

New Heritage Doll Company:: Capital Budgeting

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Applied Corporate Finance

New Heritage Doll

Applied Corporate Finance | Group 2A

New Heritage Doll Company

division one of three in the company had

Applied Corporate Finance | Group 2A

New Heritage Doll Company

New products expected to be at least as profitable as the existing ones

New Heritage Doll Company

New Heritage Doll Company

High risk discount rate 9%

Based on this information alone, project MMDC appears to be more

Applied Corporate Finance | Group 2A

Design Your Own Doll

Lower than the projected annual

Lower than the projected

Selling, General &

10 593 11 440 12 355 13 344 14 411

Income Tax at 40%

Unlevered Net Income -1 250

14 360 20 222 21 435 22 721 24 084 25 529 27 061 28 685

1 650 1 683 1 717 1 751 1 786 1 822 1 858 1 895 1 933

1 240 2 922 4 044 4 287 4 544 4 817 5 106 5 412 5 737

2 104 3 033 3 215 3 408 3 613 3 830 4 059 4 303

1 794 2 724 2 779 2 946 3 123 3 310 3 509 3 719

Design Your Own

US$ 8 427 324.

higher NPV and therefore it creates

to the assumptions made,

- perpetual life of the projects;

depending on growth rates chosen

Comparison between Investment Rules

US$ 8 427 324.

Note: The calculation of the months in the

is consistent with the fact that both MMDC

Applied Corporate Finance | Group 2A

Comparison between Investment Rules

Applied Corporate Finance | Group 2A

Comparison between Investment Rules

US$ 8 427 324.

Bearing in mind that Emily Harris must recommend only

This is also the project with lower payback periods.

Note: The calculation of the months in the

Comparison between Investment Rules

Applied Corporate Finance | Group 2A

Applied Corporate Finance | Group 2A

Applied Corporate Finance | Group 2A

One of the most important components in capital budgeting is the Terminal

Applied Corporate Finance | Group 2A

At the same time, it is important to know the estimation of the length

Applied Corporate Finance | Group 2A

So, in order to have a complete and correct analysis of the

Otherwise, if we blindly try to estimate those parameters we will

As a consequence we could end up choosing the project with the

Applied Corporate Finance | Group 2A

Applied Corporate Finance | Group 2A

When we are estimating the incremental cash flows of a project we

These externalities, when they exist, can be positive, as other products

Applied Corporate Finance | Group 2A

is the impact of each project in the other

Applied Corporate Finance | Group 2A

So, in order to have a complete and correct analysis of the