MAF302 – T1, 2017

SEMINAR 3 SOLUTIONS

Seminar 3
Capital Budgeting

Case Study

New Heritage Doll Company: Capital Budgeting

This solution is to be considered in conjunction with Excel spreadsheet Seminar 3 – New Heritage
Doll Company Solutions

Synopsis of the company and the doll industry

The doll market is a mature, slow growing business, expected to grow at only 3% in the near future. New
Heritage has grown faster than the industry but its 2009 operating margin of 6% is not particularly high.
This helps explain why the Harris is forced to pick one project over the other.

The company’s products are branded, relatively high-priced dolls and accessories aimed at a specific
market niche. Although moderately successful to date, New Heritage needs to be concerned about
competition from larger toy producers whose cost structures and product development budgets New
Heritage cannot match. From Table 1, students can see that the private label manufacturing has a higher
operating margin than branded products, possibly due to higher levels of marketing and product
development costs that branded products require. To succeed in the long run, New Heritage must have
a strategy for its branded dolls and accessories aimed at producing higher future growth and higher
margins as volumes increase.

(Tutors: a brief discussion on the difference between a branded product and a private label product is
warranted. A branded product is owned and produced by a well-known brand while a private label product
is products marketed by a retailer or other members of the supply chain. For example, Devondale milk is
a branded product while Coles milk is a private label product).

1. Compare the business case for the two projects (i.e the justification for the projects).
Which project do you think has a stronger business case?

The business case for Match My Doll Clothing (MMDC) is that it takes advantage of the current
success of the existing MMDC line. Currently, the MMDC line includes only warm clothes. The
expansion aims at creating an “All Seasons Collection” of gears. The expansion can also take
advantage of some discussed offers by suppliers and is expected to reduce the seasonality of
New Heritage’s sales and earnings which currently concentrate during the Christmas (winter)
period.

The business case for Design Your Own Doll (DYOD) is that it is based on the company’s
knowledge of its customers and their loyalty to the brand. Customers that already own a New
Heritage doll is likely to purchase further dolls if they can customize them which can in turn
cement customer loyalty to the brand.

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The two projects represent different ways to boost the brand’s growth and profitability. Both
appear compatible with the company’s strategy and have their own strong business case.
Intuition suggests that MMDC may succeed more quickly but DYOD may offer a more durable
contribution to the brand. DYOD requires nearly twice the upfront outlay as MMDC and appears
to be riskier. Different opinion would exist as to which project has a stronger business case –
MMDC offers quicker success but DYOD may offer longer term growth and value.

2. Use the operating projections for each project to compute a net present value (NPV) for
each project? Which project creates more value?

The NPV of the projects will be calculated using the operating projections provided in Exhibits 1
and 2 (see the Excel Spreadsheet accompanying this case).

A few important things to keep in mind in calculating the NPV of the projects

• The free cash flows required for NPV calculations can be estimated from the Operating
Profit. In particular Free Cash Flows = Operating Profit – Taxes + Depreciation (make
sure you understand why we add back depreciation) – changes in Net Working Capital
– Capital Expenditures. Note that Operating Profit is also referred to as EBIT
• Note that the FCF formula excludes interest (as well as other financing charges). This is
because the discount rate takes into account financing charges so including them in the
cash flow would lead to double counting. Another way to think about this is the value of
an asset should not be dependent on how it is financed. If you buy a car, does the value
of the car depend on whether you use a small loan or large loan to finance it? Hopefully,
it is clear that the answer is No. Remember to always exclude interest and other
financing charges from FCF.

Match My Doll Clothes NPV Analysis – refer to the accompanying Excel file

• The Operating Profit After Tax (Item 1) is calculated as Operating Profit Before Tax x (1-
tax rate). The cash tax rate is given in the case as 40%.
• There is an after-tax operating loss in 2010 due to the upfront R&D and marketing outlays
detailed in Table 2. These are incurred before there are any product sales; hence the
loss. The after tax loss is also smaller than the before tax loss because expenses are
tax deductible.
• Net Working Capital is calculated as Cash + Inventory + Accounts Receivable –
Accounts Payable. Hence change in the net working capital (Item 3) is the difference
between net working capital between the two years.
• Net Working Capital (Item 6) and Net Property, Plant and Equipment (Item 7) are given
in the case (Table 2)
• The FCF projections (Item 5) shows negative figures in 2010 and 2011 and generally
growing thereafter. It is always important to look at these FCF estimates and consider if
they make sense.
• The terminal value (Item 8) is calculated using the growing perpetuity formula where

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CFH × (1 + g )
Terminal Value H =
r−g

CFH in this case is cash flow in 2020

New Heritage generally uses perpetuities to estimate a terminal value for projects with going
concern value. It is debatable whether MMDC qualifies as such because this line of product
might have a limited life. Assuming that it does qualify, the terminal value can be calculated
using the above formula.

McAdams regards the MMDC project as having moderate risk, and this seems reasonable
based on the case facts. It’s an extension of an existing line, does not involve new
technologies, cost structures or even very different consumer acceptance than has already
been achieved. If McAdams’s assessment of risk is wrong, it seems more likely that the
project risk is lower than her estimate rather than higher. Accordingly, using a 8.4% discount
rate for medium risk project is a good starting point.

The perpetual growth rate is a long term growth rate. As such a long term growth rate of the
doll industry would be logical. This rate is 3% per annum despite the higher revenue growth
rate estimated in Exhibit 1.

• The concluded NPV of approximately $7.14 million is hugely affected by the terminal
value. Without the terminal value, the NPV of the project is -$147,380. As the result is
highly sensitive to the terminal value, managers might want to look at some sensitivity
analysis as well as other methodologies to estimate the terminal value. Some companies
explicitly value projects with a zero terminal value and/or consult additional metrics other
than NPV such as payback period and are unaffected by terminal value calculations.
None of these alternative methods is technically correct but it is prudent to be aware of
the effect of terminal values on concluded NPVs and to challenge terminal values that
seem biased or otherwise unreasonable.

Design Your Own Doll NPV Analysis

The calculation of this project is very similar to the other project. Few things to note:

• The case suggests that this project is riskier than MMDC. As a result, the discount rate
used in this project is 9% which is what is typically used for riskier than average projects
in the production division.
• Should the salary cost of the existing IT personnel to design and build the websites be
incorporated in the FCF estimates? The rule is if the cash flows are incremental they
should be included. In this case, Holtz seems to argue that the cost of these people is
not incremental to the project because they are already hired. However, the counter
argument is if they are not used on the DYOD project, they can be productively used in
some other projects. From this perspective, the cost of the existing IT personnel does

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appear to be incremental to the project and as such has been accounted in the project
cash flows.
• Harris should also consider and ask Holtz to what extent she believes DYOD will
cannibalize sales of other New Heritage 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? This possibility would affect the cash flow
projections.
• Despite the higher discount rate, DYOD has a higher terminal value than MMDC using
the same 3% perpetual growth rate. Does this make economic sense? It does if you
believe that DYOD represents a larger, more durable contribution to New Heritage
franchise than MMDC by further cementing the relationship between the firm and its most
loyal customers. However, both figures reflect an expectation of long term value creation.
As with MMDC, this project’s NPV is highly sensitive to the terminal value.
• The NPV of this project ($7.05 million) is positive which is in accordance with Harris’s
positive view of the project. However it’s slightly less than the NPV of the other project.

3. Compute the internal rate of return (IRR) and payback period for each project. How do
they compare to NPV as tools for evaluating projects? When and how would you use
each?

IRR Analysis

• The IRR of the two projects can be calculated using the IRR function in Excel. The results
show that MMDC has a IRR of 24% while DYOD has a IRR of 18%.
• The acceptance/rejection rule for IRR is accept projects for which IRR is greater than
the hurdle rate or cost of capital.
• The major drawbacks of IRR are: a project can have multiple IRRs particularly when
cash flows change signs repeatedly and the implicit assumption that interim cash flows
are re-invested at the IRR as opposed to the cost of capital.
• IRR is widely used in project valuation because in most cases it gives the same
investment decision as the NPV rule. In addition, IRR provides a quick indication of the
project return as compared to the required (hurdle) return.

Payback Period Analysis

• The payback period is simple to compute and indicates the amount of time required for the
company to recover the initial investments. Payback period calculations for the two projects
show that the payback period for MMDC is 7.36 years while for DYOD it’s more than 10
years. This is consistent with the notion that MMDC represents a quick hit based on the
success of a prior investment. DYOD, in contrast, exploits an existing customer base, but
must earn back significantly higher upfront development outlays.
• There is no universal rule in the use of the payback period. Some companies adopt a target
payback period, for example 5 years and are reluctant to accept projects that have longer

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paybacks. Others mainly use it to compare projects to one another, or to rank a group of
projects in which case they don’t need a particular target. Most such companies use payback
in addition to NPV which begs the question of “what does the payback period tell them that
NPV does not?”. The common response is the project with a shorter payback is less risky
and therefore preferred. However, this is not technically correct because the discount rate in
the NPV properly treats the riskiness of competing projects. The payback period may prove
useful when a company is capital constrained. For example, New Heritage’s capital budget
appears to depend on current EBITDA – the more the company earns, the more its divisions
are allowed to spend. With this budget constraint, a project with a quick payback promises
to boost the capital budget in future years and to do so sooner than a project with the same
NPV but longer payback. Obviously, how much this matters depends not only on the projects
being compared but on future projects as well. No simple rule will be reliable all the time.

4. If Harris is forced to recommend one project over the other, which one should she
recommend? What are the factors that she need to consider?

In the absence of capital constraints, both projects should be recommended based on the
positive NPVs. However, it is clear from the case that Harris does not have this luxury. The basic
calculations give very similar NPVs for the two projects 7.14 million (MMDC) and 7.05 million
(DYOD). This is not a large difference. In addition, as mentioned earlier, a going concern terminal
value for MMDC may overstate its value at the end of 2020. For example, 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.

It is unlikely that financial considerations alone will show one project to be clearly superior if
Harris is forced to recommend only one. It is likely that non-financial factors (company level
strategy, available personnel, company or division culture, a top executive’s hunch etc) also will
be considered and may even prove decisive.

The factors that she needs to consider include:

• Other investment proposals from other divisions. For example, other divisions have
valuable projects similar to MMDC. Then choosing MMDC over DYOD in production may
allow an extra MMDC-like projects to be undertaken this year that otherwise would not
be. This maybe value maximizing for New Heritage as a whole regardless of whether it
maximizes the value of the production division alone.
• The effect of each project on future budget constraints. The case mentions that New
Heritage’s constraint depends on EBITDA – the more you earn, the more you get to
spend. In the Excel spreadsheet, you can see that the cumulative EBITDA during 2011
- 2015 for DYOD’s is about $8.78 million compared with MMDC’s $6.5 million.
Accordingly, DYOD may have a relatively more positive effect on future spending limits
than MMDC.
• Harris also needs to consider if she can sequence the project ie. Can she fund one this
year and the other next year? If so, we have an investment sequencing problem.

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McAdams may argue for example that the MMDC opportunity is short-lived. If it doesn’t
get funding this year, it may not be worth doing next year, whereas DYOD is likely to still
be available next year. She argues in effect that the value maximizing sequence is
MMDC and then DYOD rather than vice versa. More generally, Harris needs to consider
if she can “save” one project for a later budget?
• Harris should also consider the possibility that one project’s NPV is more likely under or
over-stated than the other’s NPV. Earlier, it was suggested that MMDC is possibly the
beneficiary of a fad that may not last. If so, our NPV as calculated likely overstates its
value. But we should also be conscious of the ways in which we may have understated
value in our calculations. For example, we didn’t consider the value of the option to make
follow on investment (a type of real option) in the FCF projections. We know with
hindsight that the original MMDC investment resulted in a follow-on opportunity which is
the line extension now under consideration. Yet it seems likely that when the original
project was being evaluated McAdams did not include any extra value for possible
subsequent line extensions, even if she was aware of the possibility for them. If this is
so, the original project may have been undervalued. This could be true for MMDC as
well. Most companies, however, are skeptical in recognizing the value of real options
because they consider them to be “speculative” in some cases and in general are
difficulty to value.
• DYOD has potential value that is not well presented in the simple CF projections and
analyses. In Holtz’s vision, it is more than a web-based gimmick to sell a few more dolls.
It has the potential to deepen girls’ relationships with their dolls and hence to change the
relationship between the company of some of its loyal customers. The strategic
significance of this for the entire company is likely not well captured by the simple NPV
analyses.

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