The New Heritage Doll Company operates in the traditional toys and games segment of the US toy doll industry. Its two investment projects differ in initial capital outlay requirements, rates of returns, and additional tangible benefits. The company should use the perpetuity growth model to calculate the terminal values of the two projects. Since the projects are mutually exclusive, the company should select the DYOD, which has a higher NPV. NPV is used as the decision rule because it is an absolute measure of the dollar value gained or lost in a project.
Introduction
The New Heritage Doll Company is a medium size company that operates in the US toy and game industry. Dr. Ingrid Beckwith, a retired psychologist, founded the company in 1985. Emily Harris, the vice president of the company’s production division, is faced with the task of evaluating two projects, which are expanding the Match My Doll Clothing Line (MMDC) and investing in the new Design Your Doll Line (DYOD). The two projects are analyzed in the present essay. In addition, a recommendation for the better of the two projects, the one that Emily Harris should recommend to the company’s capital budgeting committee, is provided in the essay.
New Heritage Doll Company Case Analysis
The Toy Doll Industry
The US toy doll industry is divided into two segments, which are video games that dominate a 48% share and the traditional toys and games segment that dominates 52% of the market. Industry revenues totaled $42billion in 2008 and were expected to grow at a rate of 4.6% for the next five years (Luehrman and Abelli, 2010). The traditional toys and dolls market segment is further divided into four sub-segments. They are infant/preschool, dolls, outdoor and sports toys, and other toys and games. The New Heritage Dolls Company falls under the dolls sub-segment of the traditional toys and games market segment, as it produces dolls and doll accessories. The sub-segment dominates a 14.1% share of the segment’s market. Specifically, it dominates 7.332% (14.1% * 52) of the entire US toy doll industry.
A Comparison of the Two Projects
Emily Harris has to select one of the two projects and promote it to the company’s capital budgeting committee. The two projects have differences. For instance, they require different initial capital outlays. The MMDC requires an initial outlay of $3.52 million while the DYOD require an initial outlay of $6.811 million. DYOD’s initial capital outlay is significantly higher because the company has to invest a lot of money in property, plant, and equipment. Its upfront research and development costs and investment in working capital are also higher than those of the MMDC project are. The project also requires an additional $435,000 in personnel costs.
The two projects also have different rates of returns, as measured by net present value, internal rate of return, profitability index, and payback period. MMDC’s NPV is $7.1501 million while DYOD’s is $7.2981 million. MMDC’s IRR is 23.99% while DYOD’s is 18.327%.MMDC’s PI is 3.368 while DYOD’s is 2.369. Concerning the payback period, the company would recoup the money invested in MMDC after approximately 7.3 years while it would take approximately11 years to recover the money invested in DYOD.
Apart from the obvious financial benefits, the two projects would have other tangible benefits to the company. For example, the MMDC would help reduce the seasonality of the enterprise’s sales and profits. Most of New Heritage Doll Company’s sales occur during the winter holiday. The DYOD would enhance customer loyalty because the option to customize their dolls would appeal to customers.
Calculation of New Heritage Doll Company Capital Budgeting
Terminal value is the value of the cash flows expected from a project beyond the forecast period. There are three methods of computing the terminal value. They are the multiple earnings before interest, tax, depreciation, and amortization (EBITDA) method, the perpetuity method, and the perpetuity with growth approach. The perpetuity with growth approach would be used to calculate the projects’ terminal value in the case that their cash flows were to continue to grow at the rate of 3% forever. The following formula would apply to the calculation of the terminal value:
Terminal value= (FCFt+1)/ (r-g), where FCFt is the free cash flow at the last year of the projected period, r is the discount rate or cost of capital, and g is the perpetual growth rate (3%).
Use of NPV for Mutually Exclusive Projects
Mutually exclusive projects refer to projects whereby the acceptance of one leads to the rejection of the others. Therefore, only the best project is accepted while the others are rejected. NPV is the best decision rule for choosing the best among mutually exclusive projects. It is an absolute measure that indicates the dollar amount of value gained or lost by undertaking projects. It ranks projects according to the monetary value added or lost regardless of their initial capital outlays. On the contrary, IRR and PI are relative measures that indicate the rates of returns that projects offer over their lifespan. They rank projects according to their rates of returns regardless of their total value added, and initial capital outlays. Assuming that the two potential projects were mutually exclusive, Emily Harris would select the DYOD, as its NPV is higher than MMDC’s, and promote it to the company’s capital budgeting committee.
Conclusion
The New Heritage Doll Company operates in the traditional toys and games segment of the US toy doll industry. Specifically, it falls under the dolls sub-segment, which controls 14.1% of the market. It’s two investment projects, the MMDC and DYOD, have different initial capital outlay requirements. They also have different rates of returns and other tangible benefits. The perpetuity growth model would be used to compute their terminal values assuming that their cash flows were to continue growing at 3%. NPV, which is an absolute measure that ranks projects according to the dollar value added, would be used to determine the better of the two projects. The DYOD would be selected because its NPV is higher than MMDC’s.
- Luehrman, Timothy and Heide Abelli. New Heritage Doll Company: Capital Budgeting. 1st ed. Havard Business School, 2010. Print.
