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Project Analysis Services 1801 Liacouras Walk Philadelphia, PA 19122

New Heritage Doll Company: Capital Budgeting

Production Division

Proposal Recommendation October 25, 2011 Prepared For: Jonathan Scott, President Emily Harris, Vice President Prepared By: Dylan Baird Brittany Brantley David Hamme

Executive summary: Given the assumptions available to New Heritage for the forecast of their Match My Doll Clothing line (MMDC) and their Design Your Doll(DYOD) product line, we suggest New Heritage to proceed with MMDC. Despite less potential for exponential growth, MMDC is a much safer, yet more profitable, investment and does require the company to spend as much upfront. By constructing a forecast for the next ten years, we found that the MMDC expansion would have a higher NPV and IRR than the DYOD project. Furthermore, since MMDC requires a less amount for its initial investment than DYOD, it yields a higher profitability index, while having a smaller payback period. MMDC is less risky because it has less of a chance to incur a loss and will pay back the initial investment faster. If the discount rate is raised on the project, the NPV of the DYOD line decreases at a much faster rate than that of MMDC. Additionally, if the projected revenue is less than the forecast, DYOD will also suffer losses at a much faster rate than MMDC. Profitability: In analyzing the forecast for MMDC and DYOD we found that MMDC is a more profitable investment for New Heritage. The projections showed that both projects have a comparable NPV, with MMDC's at $7,164,000 and DYOD's at $7,120,000. However, though the NPV for both projects are similar, MMDC has a 24% IRR, which is 6% higher than DYOD. One factor that contributed to these findings is the initial capital expenditures for each project. MMDC's initial capital expenditure of 1,470,000 is 68% lower than the initial investment of $4,610,000 for the DYOD project, thus, despite having comprisable NPV, MMDC produces a higher IRR. Given the internal return rate is higher for the MMDC it would be more profitable in the long run and if they chose to further expand.

Another factor that determined the profitability of the two projects was the profitability index. By calculating the profitability index for both projects we determined that MMDC is, again, more profitable. For every dollar invested in the MMDC expansion, the company would receive $3.37 in return. The DYOD project, on the other hand, yields a profitability index of $1.75. The vast difference in the profitability index furthermore correlates with the payback period of the two investments. MMDC's higher profit investment ratio allows it to pay off its investment in a shorter amount of time. Besides succeeding in having a higher NPV, IRR and PI, the MMDC expansion is projected to require less capital expenditures over a ten year span, as shown in exhibit 1, giving the production division more cumulated cash flows (shown in exhibit 2) and the flexibility to expand or generate new projects. DYOD on the other hand requires a larger initial investment and capital expenditures over the next ten years, consequently giving it a longer payback period and generating a higher risk.

Capital Expenditures

5,000 4,000 3,000 2,000 1,000 0

MMDC

DYOD

Exhibit 1

Cumulated Cash Flow

Year Match My Doll Clothing Design Your Own Doll 0 -3,020 -5,331 1 -3,564 -6,592 2 -3,395 -6,257 3 -2,713 -6,566 4 -2,172 -7,755 5 -1,588 -6,667 6 -957 -5,523 7 -275 -4,311 8 461 -3,026 9 1,256 -1,663 10 2,114 -219 Exhibit 2 Risk Analysis: MMDC is clearly a less risky project. The first component to look at is the discount rate, which is .06 less for MMDC than that of DYOD. In addition to having a lower discount rate, MMDC's NPV decreases at a slower rate relative to an increase in the discount rate than DYOD. For example, if we raise both interest rates by 1/8 of their original rate, the NPV for DYOD drops from $7,118,000 to $4,364,000 about 40%, while the NPV for MMDC drops from 7,164,000 to 5,222,000, about 27%. While the project's NPV increases at similar rate relative to a decrease in the discount rate, that is; as the discount rate decreases DYOD has a faster increase in NPV than MMDC, if the New Heritage wants to minimize their chances of a loss, they should chose MMDC. The next component to examine is how a decrease in projected revenue affects the NPV. If the revenue decreases at a proportional rate for both MMDC and DYOD, DYOD suffers a greater decrease in its NPV than MMDC. Starting in year 2016, at which time there is no longer variation in the percentage increase of revenue, if the revenue of DYOD decreases by 1/8 of the estimated 6% the NPV shrinks to $3,496,000 or about 51%. However, if the revenue from the

MMDC decreases by the same proportion over the same amount of time the NPV shrink to $4,608 or about 36%. MMDC also maintains a shorter payback period. By midway through 2018, MMDC will recover all of its initial investment, where as DYOD will take until year 2020. Additionally, after year two MMDC requires very little in capital expenditures, where as DYOD will require significant capital expenditures in year four and moderate capital expenditures in the years following. Given the shorter payback period, MMDC is less subject to loss due to changes in the macro environment. If there was a recession in year 2018, New Heritage could terminate MMDC and still break even, however a recession in the same year would leave the DYOD project at a loss of about $3,500,000. Given the overall lower risk, relative to comprisable NPVs, MMDC is clearly the better choice. Marketing: MMDC is a more logical option than DYOD from a quantitative standpoint for several reasons. First and foremost, MMDC is a way to breath new life into old and existing dolls, rather than cannibalizing the market as DYOD would do. New Heritage, as its name implies, was founded on a tradition of cross-generational dolls ­ sentimentally valuable items that could be passed down from mother to daughter and actually accrue value over time. By choosing MMDC, New Heritage is able to continue generating revenue from existing customers while still staying true to the ideals upon which this company was built. DYOD would undermine the familial value of dolls that have been passed down, and would potentially reduce the role of New Heritage mothers and grandmothers in their daughters' playtime as a result.

DYOD targets a smaller market than does MMDC, causing New Heritage to miss a broader revenue stream. DYOD is limited to girls who are young enough to still want a new doll (approximately 16 and under) but who are old enough to be deemed ready to use the internet by their parents (13<). In contrast, MMDC is available to girls and women of a more diverse range of ages, and doesn't require the technical knowhow to use online "proprietary design software." Lastly, DYOD can be used almost exclusively by the party who will be receiving the doll. In other words, it is difficult to Design Your Own Doll if that doll is intended to be a gift for someone else, such as a daughter or niece. A gifter would be just as well off buying one of New Heritage's existing dolls as they would creating a customized one. The value of DYOD comes from the fact that you designed something yourself, rather than from the actual doll that results. Inversely, MMDC is a very giftable item and will be appreciated for the product, not for the process that went into selecting it. Given the above, and the fact that any one doll can have multiple outfits that will invariably go in and out of fashion, MMDC is the better choice for New Heritage.

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