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New Heritage Doll Company:Capital Budgeting Applied Corporate FinanceFebruary 20151AgendaExecutive SummaryOverview of New Heritage Doll Companys two project proposalsProjects Valuation NPV calculationComparison between Investment Rules - NPV, IRR and Payback PeriodMissing informationFinal recommendationsApplied Corporate Finance | Group 2A22Executive SummaryThe production division at New Heritage Doll Company is considering between two business proposals, which include the extension of the Match My Doll Clothing (MMDC) line and the introduction of Design Your Own Doll (DYOD). In order to select the project to be undertaken, we went through a qualitative and quantitative analysis of both projects.By performing a qualitative comparison, we found MMDC to be more compelling, as not only did it imply less costs and comparable or higher profit than the original line, but it also carried less risk, since it was the expansion of a business the company had experience with. According to our analysis, DYOD entailed high risk, since it involved processes the company didnt have experience with, had a large BEP and could lead to losing the best customers should the project fail.We then analyzed some financial metrics NPV, IRR and Payback period, and explain the contexts in which they should be used to make an investment decision and in which situations they are inappropriate. We found MMDC to have a higher NPV and a lower payback period when compared to DYOD and thus we agreed that this was the project that the company should undertake.We emphasized that these calculations and conclusions relied on a set of assumptions to which the results are sensible and we also found that important information that would help Mrs. Harris having more precise results was missing. We therefore identified key questions that should be asked to the projects sponsors. Applied Corporate Finance | Group 2A3The production division one of three in the company had two attractive project proposalsDue to financial restrictions, it was possible that only one of them would be approvedWhich project should Harris, the divisions VP, recommend to the capital budgeting committee?New Heritage Doll CompanyProblem SettingApplied Corporate Finance | Group 2A4Match My Doll Clothing Line Expansion (MMDC)Expansion of an existing, successful line from one to all four seasons of the yearLines current popularity would allow premium pricesNew products expected to be at least as profitable as the existing onesExpected off-peak discounts from suppliers and contract manufacturersExpansion would maintain or even reduce seasonality in sales and earningsRelatively large upfront R&D and marketing expenses to take advantage of the project as quickly as possible tax deductibleHarris considered the projects risk to be moderate discount rate of 8,4% (as defined by the company)New Heritage Doll Company Two Project ProposalsApplied Corporate Finance | Group 2A5Design Your Own Doll (DYOD)Targeted existing customersResearch showed many loyal customers would buy another doll if it was customizablePotential to increase customer loyaltyAs a custom product, it could carry a premium priceManufacturing expense would increaseDue to low production volume, fixed cost per unit would be high, as would the BEPRequired large investments to adapt technology infrastructure and website, since process would be carried out onlineInvolved a long development time (around 12 months)R&D and marketing expenditures would be tax deductibleRequired additional investments in equipment before 2014Would use companys existing IT staff for development work during 2011 costs not considered in initial outlays almost certainly available to work on the projectProjects 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 customersNew Heritage Doll Company Two Project ProposalsApplied Corporate Finance | Group 2A6Comparing both projects:Based on this information alone, project MMDC appears to be more compellingHigh risk discount rate 9%+ smaller potential to create valueNew Heritage Doll Company Two Project ProposalsApplied Corporate Finance | Group 2A7Projects Valuation NPV calculationFree Cash Flows were calculated based on the forecasts available. FURTHER ASSUMPTIONS:Match My Doll ClothingDesign Your Own DollDiscount rateChosen according to the risk profile of the project8.4%Medium-risk project:extension of a successful line, benefiting from its current popularity9.0%High-risk project:High BEP volume (due to high fixed costs)Longer payback periodDependent on the perfect operation of new software and user interfacesTerminal valueDuration of the projects after 2020 are not known with certainty, but it is assumed to create value indefinitely.FCF growth rateAssumed to correspond to half of the annual growth projected in 2014-20204.0%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;There may be an increase in external demand (namely from new emerging economies, due to acculturation) if American market becomes saturated.Applied Corporate Finance | Group 2A8(All values in $ thousands)2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Terminal value (2020)Revenue4 500 6 860 8 409 9 082 9 808 10 593 11 440 12 355 13 344 14 411 Production CostsFixed Production Expense575 575 587 598 610 622 635 648 660 674 Variable Production Costs2 035 3 404 4 291 4 669 5 078 5 521 6 000 6 519 7 079 7 685 Gross Profit0 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 Depreciation152 152 152 152 164 178 192 207 224 242 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%0 233 398 511 557 601 649 701 757 818 883 Unlevered Net Income-1 250 350 596 766 835 902 974 1 052 1 136 1 227 1 325 Depreciation152 152 152 152 164 178 192 207 224 242 Capex1 470 952 152 152 334 361 389 421 454 491 530 Investment in Working Capital800 94 427 84 113 121 131 142 153 165 178 Unlevered Free Cash Flows-3 520 -544 169 682 541 584 631 682 736 795 858 20 291 Discount Factor1,00 0,92 0,85 0,79 0,72 0,67 0,62 0,57 0,52 0,48 0,45 0,45 Discounted Unlevered FCF-3 520 -502 144 536 392 390 389 387 386 385 383 9 057 Net Present Value8 427 Projects Valuation NPV calculationMatch My Doll Clothing Line Extension9Applied Corporate Finance | Group 2AProjects Valuation NPV calculationDesign Your Own Doll(All values in $ thousands)2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Terminal value (2020)Revenue0 6 000 14 360 20 222 21 435 22 721 24 084 25 529 27 061 28 685 Production CostsFixed Production Expense0 1 650 1 683 1 717 1 751 1 786 1 822 1 858 1 895 1 933 Variable Production Costs0 2 250 7 651 11 427 12 182 12 983 13 833 14 736 15 694 16 712 Gross Profit0 0 2 100 5 026 7 078 7 502 7 952 8 430 8 935 9 471 10 040 Selling, General & Admin.1 201 0 1 240 2 922 4 044 4 287 4 544 4 817 5 106 5 412 5 737 EBITDA-1 201 0 860 2 104 3 033 3 215 3 408 3 613 3 830 4 059 4 303 Depreciation0 310 310 310 436 462 490 520 551 584 EBIT (Operating Profit)-1 201 0 550 1 794 2 724 2 779 2 946 3 123 3 310 3 509 3 719 Income Tax at 40%0 0 220 718 1 089 1 112 1 178 1 249 1 324 1 403 1 488 Unlevered Net Income-1 201 0 330 1 077 1 634 1 668 1 767 1 874 1 986 2 105 2 231 Depreciation0 310 310 310 436 462 490 520 551 584 Capex4 610 0 310 310 2 192 826 875 928 983 1 043 1 105 Investment in Working Capital1 000 -4 1 385 942 190 211 223 237 251 266 Unlevered Free Cash Flows-5 811 -1 000 335 -309 -1 189 1 088 1 144 1 212 1 285 1 362 1 444 24 791 Discount Factor1,00 0,92 0,84 0,77 0,71 0,65 0,60 0,55 0,50 0,46 0,42 0,42 Discounted Unlevered FCF-5 811 -917 282 -239 -843 707 682 663 645 627 610 10 472 Net Present Value6 879 10Applied Corporate Finance | Group 2AProjects Valuation Match My Doll Clothing(MMDC)Design Your Own Doll(DYOD)Discount rate8.4%9.0%FCF growth rate4.0%3.0%NPVUS$ 8 427 324. 21US$ 6 878 750.81The Match My Doll Clothing has an 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 chosenMMDC/ DYOD0,0%0,5%1,0%1,5%2,0%2,5%3,0%3,5%4,0%0,0%MMDCMMDCDYODDYODDYODDYODDYODDYODDYOD0,5%MMDCMMDCMMDCDYODDYODDYODDYODDYODDYOD1,0%MMDCMMDCMMDCDYODDYODDYODDYODDYODDYOD1,5%MMDCMMDCMMDCMMDCDYODDYODDYODDYODDYOD2,0%MMDCMMDCMMDCMMDCMMDCDYODDYODDYODDYOD2,5%MMDCMMDCMMDCMMDCMMDCMMDCDYODDYODDYOD3,0%MMDCMMDCMMDCMMDCMMDCMMDCDYODDYODDYOD3,5%MMDCMMDCMMDCMMDCMMDCMMDCMMDCDYODDYOD4,0%MMDCMMDCMMDCMMDCMMDCMMDCMMDCMMDCDYODProjects NPVDepending on growth ratesMMDCDYOD0,0%393231850,5%424536191,0%460041081,5%500746622,0%547752962,5%602760263,0%667968793,5%746478864,0%8427909511Applied Corporate Finance | Group 2AComparison between Investment RulesNPV, IRR and Payback PeriodIf Emily Harris evaluates both proposals as stand-alone 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.Match My Doll Clothing(MMDC)Design Your Own Doll(DYOD)Discount rate8.4%9.0%NPVUS$ 8 427 324. 21US$ 6 878 750.81IRR15.91%13.02%Payback Period8 years and 1 month10 years and 4 monthsAdjusted Payback Period11 years and 9 months17 years and 6 monthsNote: The calculation of the months in the normal and adjusted Payback Period was made assuming that FCF are distributed evenly throughout the year.12Applied Corporate Finance | Group 2AComparison between Investment RulesNPV, IRR and Payback PeriodWhen 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.13Applied Corporate Finance | Group 2AComparison between Investment RulesNPV, IRR and Payback Period 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.Match My Doll Clothing(MMDC)Design Your Own Doll(DYOD)Discount rate8.4%9.0%NPVUS$ 8 427 324. 21US$ 6 878 750.81IRR15.91%13.02%Payback Period8 years and 1 month10 years and 4 monthsAdjusted Payback Period11 years and 9 months17 years and 6 monthsNote: The calculation of the months in the normal and adjusted Payback Period was made assuming that FCF are distributed evenly throughout the year.14Applied Corporate Finance | Group 2AComparison between Investment RulesNPV, IRR and Payback PeriodWhen 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.15Applied Corporate Finance | Group 2AMissing InformationIn 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?

16Applied Corporate Finance | Group 2AMissing InformationIn 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?

17Applied Corporate Finance | Group 2AMissing InformationWhat 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 ProjectG=3% => NPV=$6 879 KDYOD ProjectG=4% => NPV= $9 095 KDYOD ProjectG=2% => NPV=$5 296 K- 1%+ 1%MMDC ProjectG=4% => NPV=$8 427 KMMDC ProjectG=5% => NPV= $11 209 KMMDC ProjectG=3% => NPV=$6 679 K- 1%+ 1%18Applied Corporate Finance | Group 2AMissing InformationWhat are the long run growth prospects? How long are the projects expected to last? 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.DYOD ProjectG= 35 => NPV=$4 105 KMMDC ProjectT= 25 => NPV=$3 401 KDYOD ProjectG= => NPV=$6 879 KMMDC ProjectT= => NPV=$ 8 427 K19Applied Corporate Finance | Group 2AMissing InformationWhat are the long run growth prospects? How long are the projects expected to last?

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.20Applied Corporate Finance | Group 2AMissing InformationIn 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?

21Applied Corporate Finance | Group 2AMissing InformationWhat is the impact of each project in the other business segments of the company?

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.22Applied Corporate Finance | Group 2AMissing InformationWhat 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.23Applied Corporate Finance | Group 2AMissing InformationWhat is the impact of each project in the other business segments of the company?

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.

24Applied Corporate Finance | Group 2ATaking 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

Overview & Final Recommendations25Applied Corporate Finance | Group 2AMMDC 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 risksIRR measures the average return of the investment, so it is a measure that is not affected by the scale of the investmentRanking projects by their IRR ignores risk differences

Different scales of Initial Investment

MMDC lower investment3520 thousand dollars

DYOD has a higher investment5811 thousand dollarsDifferent levels of RiskProjects cost of capital is determined by the projects risk

MMDC has a moderate riskLower discount rate = 8,4%

DYOD has high riskHigher discount rate = 9%Overview & Final Recommendations26Applied Corporate Finance | Group 2AThe 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 onceEither way the projects have different costs of capital, so it is not obvious what cost of capital the incremental IRR should be compared toUsing 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.

Overview & Final Recommendations27Applied Corporate Finance | Group 2ANew Heritage Doll Company

Applied Corporate FinanceFebruary 2015Q&A28