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New Heritage Doll Company- Capital Budgeting Case Solution
Match my doll clothing line currently comprises of matching doll and child clothing and accessories for warm weather only. This line is very profitable because of its popularity and it is the in-fashion thing now-a-days. Daughters of a few celebrities have been found wearing these outfits and trendy magazines include these outfits in their hot section which make them highly desirable by the general populace. Expanding this line to cater to all seasons is a lucrative opportunity.
Given the popularity of the line, it is the best time to expand the line because this popularity ensures premium prices and high profitability. It also helps to smooth the seasonality of sale. Since the line will now cater to all seasons so, the sales would not be concentrated in the warm season only. Expanding this line will also result in higher profits since the suppliers offer discounts in the off season to maximize their capacity utilization resulting in lower product costs.
There is urgency in starting up this expansion project because the popularity of branded dolls has seen ups and downs in American market. Most of the New Heritage dolls have also lost their popularity after a few years. So, if the project is not started now, the popularity of the dolls may fade away, and New Heritage may never reap the profits available right now.
Following questions are answered in this case study solution:
Comparison of the business cases
IRR and payback period analysis
Analysis of additional information
New Heritage Doll Company Capital Budgeting Case Analysis
The project incorporates lower fixed costs which will enable New Heritage to breakeven at lower sales volume, but has relatively higher payouts for Research and Development. The project is similar to the existing projects of New Heritage and faces a moderate risk like the other projects.
The cash flows of this project stabilize after the first three years of operation i.e. the product line matures in 3 years of the operation. Also, the net working capital requirement of this project stabilizes in three years of operation, and is much lower as compared to the other project.
Design Your Own Doll
Design Your Own Doll project targets the existing customers of the company, who already own one of the dolls of the company. The project calls for the involvement of the customer in the production process of the dolls and allows the customer to make a doll of her own choice. This would allow the customer to choose the skin, clothing and accessories for the doll as she likes, making a one-of-a-kind doll. The preliminary marketing research has found that customers are very excited about the idea and are willing to buy a doll which they make from their own preferences, and are willing to pay premium prices for this feature. The customers also like this idea because of the girls’ participation in the making of the doll. All these features add to the loyalty of the customer with the company, and if this project is taken up, the brand equity of the company will be highly escalated. The project calls for making a web-based interface where the customers can design a doll and then place an order.
There are downsides of the project, as well. It is highly unlikely that customers will come back to the website after the first purchase and design a doll from the same accessories and features. Since there will be lower production runs and volume for this line, the higher fixed costs per unit will result in higher breakeven sales and volume.
There is also a significant working capital requirement for this project because of high requirement for half-finished dolls at all times. Also, the cash flows of this project stabilize after 6 years of initial investment (4 years after the production starts). The company has no prior experience in such projects and the project calls for incorporation of new technology. There is also a risk that the web-based interface may not work properly resulting in the loss of loyal customers.
NPV gives the direct value that the project adds to the firm whereas it ignores the size of the project and the goodwill that a project can generate if taken up. It only values a project on its financial aspect while neglecting all non-financial aspects such as customer loyalty and brand equity. The detailed NPV analysis is done in the accompanying Excel file. The cash flow forecasts were computed on after tax basis and exclude the finance charges that may be incurred in case any loans are taken for funding the projects. This is because the finance charges are included in the discount rate used to calculate the present values of the cash flows.
The experience of the company with projects similar to Match My Doll Clothing Line Expansion project, similarity with the current projects of moderate risks, and the relative stability of the cash flows of the project depict that it is a moderate risk project. Design Your Own Doll project needs new customer acceptance, new technology, has higher fixed costs, higher working capital requirement and lower stability of cash flows than the normal projects of the company. So, it is a high risk project.
For 2010, moderate risk projects are discounted at 8.4% while high risk projects are discounted at 9% per year.
The NPV of to Match My Doll Clothing Line Expansion project is $38,758.32 while the NPV of the Design Your Own Doll project is $19,095.83. The NPV of to Match My Doll Clothing Line Expansion project is higher by $19,662.49.
NPV analysis shows that Match My Doll Clothing Line Expansion project is highly profitable as compared to the other one.
Internal Rate of Return
Internal Rate of Return evaluates a project on the returns that it generates on the amount invested in the form of a percentage. Both NPV and IRR consider the time value of money, risk of the cash flows and the value generated for the company but there is a disadvantage to IRR that it may give contradictory results as compared with NPV. However, this is not the case in our analysis. The IRR of Match My Doll Clothing Line Expansion project is 35% while the IRR of Design Your Own Doll project is 21%.
Payback Period Analysis
Payback period method values a project on the time period that it takes to return the initial investment. The advantage of using payback period method is that it selects the project that recovers the initial investment quickly. There are some major disadvantages of using this method. This method does not consider the time value of money, the risk associated with the cash flows and the cash flows received after the payback period. This may not result in the most favorable decision choice for the company. The Payback period for Match My Doll Clothing Line Expansion project is 7.38 years while for Design Your Own Doll project is 9.98 years.
Discounted Payback Period Analysis
While discounted payback period method considers the time value of money, it still does not consider the cash flows received beyond the payback period and thus may not result in a right decision. The Discounted Payback period for Match My Doll Clothing Line Expansion project is 8.87 years while for Design Your Own Doll project is greater than 10 years.
Analysis of additional information
There are small numbers of large producers in the doll industry, and there is no mention that any company has introduced a customized doll line. Since there are a small number of producers, we can safely assume high price competition between the producers in order to get the market share. So in such a market, building a brand name can be very beneficial for the company to retain its customers. Also, if New Heritage Doll Company starts custom-made dolls line, it may be able to snatch market share from its competitors while charging premium prices at the same time. This also coincides with the “innovative startup” feel of the company which reflects itself in the capital spending in the company.
The maximum age targeted by the company is 12 years old girls. Generally, children of such age do not use the computers frequently, and mothers usually tell the children of such age to play some physical sport. This makes the project riskier because the young girls may not be allowed to use computers. Also, children are more attracted towards buying the things which their favorite characters use. So, expanding the clothing line may be more appealing to the girls of age 12 and lower.
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