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NEW HERITAGE DOLL

COMPANY: Capital Budgeting


• Match My Doll Clothing (MMDC) is an opportunistic,
but entirely logical, follow-on investment that builds on a
prior success.

• Design Your Own Doll (DYOD) is based on the


company’s knowledge of its customers and their loyalty
to the brand.

• Intuition suggests that the former may offer quicker


success, but the latter a more durable contribution to the
franchise.
Estimating Net Present Value
• The main ingredients are
• the initial investment,
• expected future cash flows,
• A discount rate, and
• A terminal value
Expected cash Flows

• EBIT (1-t)
• Add: Depreciation
• Less: Change in NWC
• Less: Capital expenditure
• = Free Cash Flow
Discount rate
• New Heritage assigned discount rates to projects
according to a subjective assessment of each project’s
risk.
• In 2010, “low” risk project is assessed at 7.7%
• “medium” risk project is assessed at 8.4%
• “high” risk project is assessed at 9%
Terminal value (TV)

• The TV is modeled as a perpetuity with a constant


growth rate, g. This is a common way to model a going
concern.

• Of the two New Heritage projects, DYOD is likely more


compatible with the notion of a perpetual going concern
than MMDC.
• MMDC is highly dependent on the company’s ability to
anticipate or at least react quickly to changing fashion
trends and may consequently have a comparatively
short life.
• MMDC
• Why there is an after-tax operating loss in 2010, and why
it is smaller than the pre-tax loss?

• The pre-tax loss is due to the upfront R&D and


marketing outlays summarized in Table 2 (case). These
are incurred before there are any product sales; hence
the loss.
• The after-tax loss is smaller because the expenses are
deducted and the calculations assume that New
Heritage will be a tax payer in 2010; i.e., that it can use
the deduction from this project immediately.
Calculation of Change in NWC

• Calculation for the year 2011($ in thousands)


• Cash = 3% of sale = 0.03 x 4500 = 135
• Account Receivable= (59.2 / 365) x sales = (59.2/365) x 4500
= 729.86
• Inventory Turnover = 7.7 = Prod. Cost / Cl. inventory
Cl. Inventory = Prod. Cost / 7.7 = 2762 / 7.7 = 358.7
• Accounts Payable = (30.8 /365) x Total operating expenses
excluding depreciation = (30.8 /365) x (3917 – 152)
= (30.8 /365) x 3765 = 317.7
• NWC = 135 + 729.86 + 358.7 – 317.7 = 906
• Change in NWC = +106
No charge for real estate or
other corporate overheads
• Why the projections include no charges for real estate –
e.g., space in New Heritage or other buildings – and/or
other corporate overhead.
• Let us suppose the project actually uses some space
and corporate resources. Should we try to estimate their
cost and include them in the cash flows? Only if they are
incremental.
• If New Heritage already has the space, and no
incremental cash rent charges (for example) are incurred
on account of accepting the MMDC project, then our
exclusion of this item may be proper.
• But before concluding this is so, we must also consider
whether there is an opportunity cost associated with
having MMDC occupy the space.
• The pertinent question is: what would happen to the
space if the project is not accepted?
• If the answer is “nothing”, then we were justified in
excluding it from our cash flow projections.
• But if the New Heritage could rent out the space to a
third party, or would have made some other productive
use of it, then accepting the MMDC project has an
opportunity cost – the foregone rent – which should be
reflected in the cash flow projections.
Terminal value
• New Heritage generally uses perpetuities to estimate a terminal
value for projects with going concern value. It certainly is
debatable whether MMDC qualifies as such, but assuming it
does, the basic calculations are straightforward:
• They require a perpetual growth rate, a beginning cash flow, and the
discount rate of 8.4%.
• 3% as a growth rate because it appears in the case text (US dolls
sales are projected to grow at 3%, but NH has been growing faster).
• The concluded TV of $16.35 equals [$857 x 1.03] / (0.084-0.03).
This figure is discounted to 2010 at 8.4% at $7.296.
• The NPV appeared in the Table 1 is $7.15 million which is hugely
affected by the terminal value calculation.
• To see this, note that the NPV excluding the terminal value is -$1.46
million. Many real world managers are dismayed by this
characteristics of the analysis and address it several ways.
•DYOD
Some points which deserve special mention:
Harris should ask Holtz to what extent she believes DYOD will
cannibalize sales of other New Heritages Dolls.

• The case says DYOD will stimulate loyal customers to purchase


another doll.
• But might they have purchased an existing New Heritage doll if
DYOD were not offered?
• Could you tell , at least qualitatively, how this possibility would affect
the projections and financial analysis?
• The project description for the DYOD investment
incorporates full-time use of several IT personnel to
design and build out the website. Associated costs
are not included in the projections presented in
Exhibit 2. Should they be?
• Holtz’s argument appears to be that these are not
incremental hires due to her project – the people already
work for New Heritage.
• Some of you may agree and further point out not only
have the people already been hired but they won’t be
fired if the project is not undertaken.
• The argument is that the cost of these people is not an incremental
cash flow.
• However, the counter-argument is that while the people in question
may be on the payroll regardless of the project, they would be
productively used on some other project if DYOD is not undertaken.
Indeed, if this were not the case, they might well be fired!
• According to this argument, the use of the IT personnel for DYOD is
an opportunity cost that should be included as part of the NPV
analysis. Harris should ask Holtz to support her contention that
incremental cost is zero.
• We have treated these costs as opportunity costs and incorporated
them into the cash flow calculations as “Additional development cost
(IT personnel)” of $435 in 2011.
• We don’t know what Holtz ultimately told Harris
about the riskiness of DYOD, but the case suggests
that it is riskier than MMDC.
• We apply a discount rate of 9% - the rate given in the
case for riskier-than-average projects in the production
division.
• The concluded NPV for DYOD is $7.06
million. This is positive, in accord with
Harris’s positive view of the project, but it
is less than the NPV of $7.15 million for
MMDC shown in Table 1.
Additional calculations
• The case mention that NH’s capital
budgeting committee requires these
calculations, along with unspecified others,
routinely.
• Table 1 presents
• IRR
• PB
• PI
Comparing MMDC and DYOD
Table 1: Summary of Investment Metrics for MMDC and DYOD

MMDC DYOD
NPV $7.15 million $7.06 million
IRR 24.0% 17.9%
Payback 7.4 years >10 years
Profitability Index 2.37 1.32
5-year cum. EBITDA $6.52 million $8.78 million
Which project should be selected?
• Similar NPV for the two projects: $7.15 million and $7.06 for MMDC
and DYOD, respectively.
• This is not a large difference.
• Moreover, as mentioned earlier, a going concern terminal value
for MMDC may overstate its value at the end of 2020. To
illustrate, note that lowering the perpetual growth rate to 2% for
MMDC and leaving DYOD’s growth rate at 3% makes MMDC’s NPV
lower than DYOD’s (See Table 2).
Table 2: NPV Sensitivity Analyses
NPV of Match My Doll Clothing Line Extension

TV growth rate

Discount 0% 1% 2% 3% NPV if
rate TV=BV
of
NWC +
PPE

7.70% $ 5,289 $ 6,141 $ 7,292 $ 8,932 $ 3011

8.40% $ 4,408 $ 5,075 $ 5,950 $ 7,150 $ 2,687

9.00% $ 3,766 $ 4,314 $ 5,019 $ 5,958 $ 2,425


Investment sequencing problem

• Harris must choose between the two projects.


• Could she fund one this year and other next year?
• If so, we have an investment sequencing problem.
• Ms. McAdams may argue, for example, that the MMDC
opportunity is fleeting – if it does not get funding this
year, it may not be worth doing next year, whereas
DYOD is likely to still be available next year.
• Thus, value maximizing sequence is MMDC, then
DYOD, rather than the vice versa.
Strategic significance of DYOD

• DYOD has potential consequences that are not well


represented by the simple cash flow projections.
• In Holtz’s vision it is more than a mere web-based
gimmick for selling a few more dolls; it has the potential
to deepen girls’ relationship with their dolls and hence to
change the relationship between the company and some
of its most loyal customers.
• The strategic significance of this for the entire company
is likely not well captured by the simple NPV analysis
that will be presented to the committee.

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