NEW HERITAGE DOLL

Group 3

William Ma|16.6%
Andrew Wang|16.6%
Davy Zhou|16.6%
Jackson Lam|16.6%
Paul Tsihlis|16.6%
Keith Wong|16.6%

Group 3 1|Page
Executive Summary
Problem Statement
Emily Harris, the Vice President of the New Heritage Doll (NHD) Companys Production Division, is currently
deliberating between the selection of two project proposals, namely Design Your Own Doll Clothing (DYOD) and
Match My Doll Clothing Line Expansion (MMDC). At the upcoming capital budgeting meeting, she must be prepared
to offer her recommendation for the most optimal proposal with regard to its quantitative and qualitative benefits
for NHD. The following Case Report provides a justification and recommendation for the project proposal Harris
should advocate to the capital budgeting committee for NHD to pursue.

Case Report Objectives

The objectives of the Case Report are outlined below:

To assess the validity of both proposals under consideration by Emily Harris, and to provide an indication of
the more compelling proposal for the NHD Company;

To compute the NPV of both proposals and to provide a judgment for which project creates the most value
for the NHD Company. This valuation is supplemented by IRR and Payback Period analysis, along with a Risk
Analysis capturing the sensitivity of each proposals NPV to adjustments in the projected sales revenues,
sales quantities, variable costs and revenue growth rates;

To perform a qualitative analysis of both proposals; and

To identify the additional information required by Harris to more accurately complete her comparative
analysis of the proposals and recommendation for which proposal should be pursued.

Findings
The major findings of the Case Report are summarised below:

The MMDC project proposal was deemed to be a more compelling business case as it was associated with a
lower level of risk and it involved the expansion of an already successful product range. Conversely, the
DYOD project was associated with higher levels of risk, the installation of complex technology and required
flawless operation to be successful;
The results of the NPV analysis confirms that the MMDC project is a superior project choice to the DYOD
project on the basis of its higher NPV, higher IRR and lower payback period. Therefore, through NPV
valuation, MMDC is a more compelling value-creation business case for NHD; and
The results of the Risk Analysis confirmed that the MMDC project is generally less sensitive than the
DYOD project to adverse changes in a variety of factors, such as variable costs, sales revenue and
terminal value growth. In addition, the MMDC project maintains a desirable relationship with the
discount rate. Therefore, this analysis suggests MMDC is a more compelling project; and

Recommendations
Based on the projections given in the Case Brief, it is advised that Harris should recommend for NHD to pursue the
MMDC project proposal at the upcoming capital budgeting committee meeting. This recommendation is supported
by the higher NPV and more compelling business case offered by the MMDC project in comparison to the DYOD
project. However, prior to a final decision, it is also highly recommended for Harris to obtain additional relevant
data, in particular, pertaining to the incremental project cash flows and more accurate forecasts of the lives of both
proposals in order to foster a more accurate quantitative valuation analysis of both projects.

Group 3 2|Page
Business Case Analysis
Background and Trends in the Doll Industry
The U.S. Toy and Game industry produced USD$42 billion in revenue in 2008, with this figure projected to increase
by 4.6% per year. This industry segment is dominated by the presence of large global enterprises enjoying the cost-
reduction benefits of economies of scale, and with highly seasonal revenues. Within this industry, the retail sales of
dolls totalled USD$3.1 billion in 2008, with this figure projected to increase by 3% per year. The Doll Industry is
subject to a number of trends, which may impact the revenue growth in specific sub-segments. In particular, the
trend of Age Compression, whereby younger children tend to acquire the dolls originally designed for older girls,
has reduced growth in the baby-doll segment.

Background of New Heritage Doll (NHD) Company

The NHD Company, founded by Ingrid Beckwith in 1985, stands by its vision to create a line of dolls that foster
imagination and healthy self-image. As of 2010, the range of products at NHD is comprised of Celebrity Dolls (price
range of $75-$150), High-End Dolls (price range of $75-$150) and Baby Dolls (price range of $15-$30). The target
market for Baby Dolls consists predominantly of girls aged three to twelve years. On the other hand, the Celebrity
and High End Dolls are directed towards older girls, as these dolls are associated with a sense of culture and family
tradition.

Quantitative Project Valuation

NPV Analysis
In a quantitative sense, the NPV valuation of the proposed projects can be achieved by Harris through the
construction of a Discounted Cash Flow (DCF) analysis. The major assumption governing the DCF analysis is given
below:

Enterprise Value = Sum of PV of Free Cash Flows (FCFs) + Terminal Value

whereby the Terminal Value is calculated as a growth perpetuity as the projects are going concerns with
perpetual life.

As per the Case Brief, the projected increase in US retail doll sales is 3%, and the projected sales growth of the
MMDC and DYOD projects are 8% and 6%, respectively. Therefore, in compliance with the capital budgeting
committee requirement for the growth rate to be less than the forecasted divisional and historical company growth
rates, a growth rate of 3% was employed for the purpose of the NPV valuation. The corporate tax rate of 40% was
also applied and held constant over the perpetual lives of both projects.

The calculation of the FCFs, Net Working Capital and NPV is summarised using the formulas in Appendix A. The
calculation of the net working capital and NPV for the MMDC and DYOD projects are captured in Appendix B and
Appendix C, respectively. Of particular note, the depreciation method employed in the NPV valuation is according to
the modified accelerated cost recovery system (MACRS). Additionally, the terminal value has a significant bearing on
the final NPV and it is captured in the formulas across Appendix A to Appendix C. Furthermore, the discount rate
applied in the PV calculations for both projects differs as a result of the risk-status of the projects. In particular,
MMDC was considered a moderate-risk project, whereas DYOD was considered as a high-risk investment project.
Consequently, the discount rates for MMDC and DYOD are 8.4% and 9%, respectively.

Employing the above assumptions, a NPV of $7,171,900 and $7,112,900 was calculated for the MMDC and DYOD
project, respectively. These values indicate that the MMDC project represents a superior choice as it contributes to
greater firm value than DYOD project. Secondary economic indicators for both projects were also generated. In
particular, the IRR of both projects was calculated, standing at 12.191% and 1.572% for MMDC and DYOD,
respectively, along with the payback period of both projects, which stood at 6.3 years and 9.5 years for MMDC and
DYOD, respectively. In assessment of the projects IRR, it is clear that the MMDC project would be accepted as its IRR
exceeded the hurdle rate used in the discounting of FCFs.

Group 3 3|Page
Overall, the result of the NPV analysis confirms that the MMDC project is a superior project choice than the DYOD
project on the basis of its higher NPV, higher IRR and lower payback period.

Risk Analysis
As a result of the large number of assumptions employed in the NPV Analysis, a Risk Analysis was conducted. The
Risk analysis consisted of three components, namely a Break-Even Analysis, an Elasticity Analysis and a Sensitivity
Analysis.

Break-Even Analysis
A Break-Even Analysis was utilised to determine the dependency of the NPV of both projects on four key variables,
namely revenue, terminal value growth, variable costs and discount rate. It was found that the break-even point for
revenue required a 6.13% decrease for the MMDC project in comparison to a 3.12% decrease for the DYOD project.
Additionally, the breakeven point for variable cost required an increase in costs for the MMDC and DYOD projects of
11.24% and 5.27%, respectively. The break-even points associated with revenue and variable costs suggests that the
MMDC project is less sensitive to changes. Furthermore, the break-even points for both the terminal value growth
and the discount rate confirmed that the MMDC project is less sensitive to adverse changes in the aforementioned
factors. A full summary of the results of the Break-Even Analysis is contained in Appendix D.

Elasticity Analysis
In a similar fashion, an Elasticity Analysis of the NPV with respect to the same factors applied in the Break-Even
Analysis was used to measure sensitivity. A full summary of the results of the Elasticity Analysis is contained in
Appendix E. It was found that, with the exception of MMDCs NPV to terminal growth elasticity being higher, the
elasticity analysis details that the MMDC project is less sensitive (more inelastic) to changes in the revenue, variable
cost and discount rate than the DYOD project.

Sensitivity Analysis
Finally, in order to reinforce the conclusions regarding the MMDC and DYOD projects sensitivities, a Sensitivity
Analysis was conducted. The A full summary of the results of the Sensitivity Analysis is contained in Appendix F.
Evident in Appendix F, it is clear that the MMDC project is typically less sensitive than the DYOD project to the
applied factors. Thus, this analysis is suggestive of the compelling nature of the MMDC project.

Qualitative Project Analysis

NHDs capital budgeting committee employs a specific set of qualitative criteria in the approval process of project
proposals.

The first criteria involves how consistent the project is with NHDs business strategy to develop the girls
imagination and foster positive self-image. The MMDC project succeeds in fostering positive self-image as a result of
the doll clothing designs meeting the current trends in celebrity clothing and girls magazines. In spite of the expected
success of the MMDC project, the unique nature of the product range associated with the DYOD project results in
the DYOD project being more a favourable proposal. In particular, each doll is tailored specifically towards individual
customers, while simultaneously, allowing them to develop their imaginations by participating in the design process.

The second criteria in the analysis of project proposals involves ensuring that consistency is maintained between the
priorities of the projects, and the financial and organisational constraints of NHD. A key consideration that must be
made is the limited discretion of the capital budgeting committee to expand and contract NHDs budget. In a
valuation sense, the MMDC project has a higher NPV, as well as a lower initial capital expenditure. Conversely, the
DYOD project is associated with two initial capital outlays, and it is also more sensitive to changes in sales revenue
and variable cost. Given the limited discretion of the capital budgeting committee, the MMDC project would be the
preferred project under this criteria.

The final criteria incorporates the benefit of each project to NHD on a firm-based level, rather than a divisional level.
The MMDC project has the advantage of enabling the firm to make use of supplier discounts, which in turn, lower its
WACC and makes it easier to attract capital. Additionally, the positive publicity achieved by matching the doll design
Group 3 4|Page
to celebrity clothing trends has increased the market awareness and exposure to NHD. Contrastingly, the drawback
of the DYOD project is its tailoring to the existing customer base. The unique nature of the product aligns with the
firms business strategy, however it also results in lower production volumes and a higher WACC relative to the
MMDC project. Finally, DYOD is a much riskier project as it requires flawless operation; this added risk impacts
negatively on New Heritage. Overall, employing the projections provided in the Case Brief, the MMDC project should
be pursued as it satisfies the requirements of the capital budgeting committee at the NHD Company.

Additional Information Requirements

The quantitative and qualitative analysis above provides a reasonably accurate estimate of project value. However,
in consideration for the dynamic nature of the real world, Harris requires additional information to obtain a more
accurate evaluation of both projects. This additional information required is detailed below.

In the estimation of incremental project cash flows, it is essential to consider the impact of each proposed project on
the cash flows of other divisions of the company. There may be positive effects, such as an increase in sales, as well
as negative effects, such as cannibalising other company products. For example, the MMDC project could increase
sales in other divisions, as customers demand clothes to compliment their dolls. Similarly, the DYOD project may be
able to increase demand in other product lines such as doll accessories as a result of introducing a customised doll.
However, as the MMDC project is an expansion of an existing product line, there is a tendency for it to have minimal
cannibalisation relative to the DYOD project, which involves the introduction of a new product line. Thus, it is
essential to acquire data regarding spill-over effects to perform an accurate analysis of the incremental cash flows
generated by each project.

Identified in the NPV valuation of the non-perpetuity scenario, information regarding the terminal value growth
rates of both projects should also be obtained. The assumption of a constant positive perpetuity growth rate on a
going concern basis beyond 2020 may be unrealistic given the oligopolistic nature of the market, particularly with
Barbies dominance. Furthermore, information regarding each projects length must be obtained. More accurate
forecasts of the lives of both the DYOD and MMDC project are essential as the length of each project creates
fluctuations in the attained NPVs.

Furthermore, scenario analysis could not be performed as no information was provided regarding economic and
market conditions, or the probability distributions of revenue and cost drivers. Optimally, this information is
required to obtain a better evaluation of the projects through a Monte Carlo simulation.

Recommendations
As Harris must recommend one project to be pursued by NHD Company at the upcoming capital budgeting
committee meeting, it is clear that the MMDC project should be selected for the following reasons.

In a valuation sense, the MMDC project is the superior investment choice compared to the DYOD project as it has a
greater NPV and IRR and a lower payback period. This suggests that the MMDC project will add more value to the
firm, earn a superior return and pay back the initial investment earlier, freeing up the use of funds for NHD to focus
on other purposes. Additionally, the MMDC project is more favourable in terms of elasticity and sensitivity,
indicating a lower risk of fluctuations over the projects lifespan.

Furthermore, from a qualitative standpoint, the MDMC project is superior due its expected synergy and ability to
strengthen other segments of the company. The project requires lower operating costs and brings a lower level of
risk whilst being able to take advantage of the market traction of NHD, as it is an extension of an existing successful
product line. In comparison, the DYOD project generates high levels of project risk. If the project fails, it would
damage relationships with NHDs best customers. Thus, on the basis of the given data, it is strongly recommended
that Harris propose the Match My Doll Clothing (MMDC) project over the Design Your Own Doll (DYOD) project to
the NHD capital budgeting committee.

Group 3 5|Page
Appendix

Appendix A Project Valuation: Equations used in NPV Calculation

Group 3 6|Page
Appendix B Project Valuation: MMDC - NWC Calculation and NPV Calculation

Group 3 7|Page
Group 3 8|Page
Appendix C Project Valuation: DYOD NWC Calculation and NPV Calculation

Group 3 9|Page
Group 3 10 | P a g e
Appendix D Risk Analysis: Break-Even Analysis

Variables was multiplied by a specific pronumeral: the factor must decrease the overall sales revenue to
reach break-even point. Consequently, the NPV was expressed as with that specific variable. NPV was set to
0 and Excel Goal seek was utilised to determine the corresponding variable.

Group 3 11 | P a g e
Appendix E Risk Analysis: Elasticity Analysis

A 1% increase in the variables were assumed. The variables were each multiplied by 1.01 to find the new
NPV. The elasticity formula was subsequently applied.

Group 3 12 | P a g e
Appendix F Risk Analysis: Sensitivity Analysis

Sales revenue sensitivity

In order to calculate the NPV for different values of sales revenue, we used the new NPV of NOPAT, and
the new NPV of change in NWC. Next we subtracted the old NPV of NOPAT and added the new NPV of
NOPAT and old NPV from change in NWC and deducted the new NPV from change in NWC. Throughout
the calculation we accounted for the effects of revenue on required cash on hand and accounts receivable
and made assumptions that Selling General and administrative expenses change according to its historical
average 25% of sales revenue.

Terminal growth rate sensitivity

We separated the terminal value for a range of terminal growth rates and then included this with the PV of
FCF that did not include the terminal value.

Variable cost sensitivity

We took a similar approach to above and took old and new values of the NPV of NOPAT and change in
NWC and adjusted accordingly. Throughout the calculation, we accounted for the change in variable costs
against accounts payable. We also made assumption that variable costs would be multiples of the current
numbers and we did not consider economies of scale and any boosts or losses in inefficiency as capacity
increases due to insufficient information.

Discount rate sensitivity

Using the given free cash flow for each period, we determined a range of NPV resulting from the range of
discount rates. An important consideration we made was the adjustment of the terminal value growth and
therefore FCF in 2020 as it is also correlated with the discount rate.

Group 3 13 | P a g e
Group 3 14 | P a g e