New Heritage Doll (NHD)

1) Briefly discuss one aspect of the capital budgeting process at NHD that you believe may be problematic. Focus on the process as described in the case.

The aspect of the capital budgeting process at NHD which could be problematic is the open nature of projects which are deemed to have a perpetual return. While the discount rate determination is also open to interpretation, there are only 3 options provided, and each can be run as a sensitivity analysis. For determining a value of a perpetual project (often via a terminal value), leaving the growth rate to be used open to interpretation can present challenges. Especially as these projects often tend to be dependent on or impact other projects. Evaluating them compared to other projects without a terminal value may result may be impossible. At the very least, a defined ranking of tools (for example: NPV, then IRR, then payback) and a defined process for comparing perpetual and non-perpetual projects would help to reduce this concern.
Figure 1: The current process 1) Capital budget was set by the board of directors (in consultation with top officers, who drew on input from divisions). The Capital and operating budgets were linked, with capital being equal to approx. 15% of companys EBITDA. 2) Projects were set up and described by each division proposing them before coming to the capital committee. The capital budgeting committee is comprised of the CEO, CFO, COO, the controller, and the division presidents. 3) Revenue projections were based on future prices and volumes. Costs were estimated by expense category. Working capital requirements were based primarily on inventory requirements. Fixed asset and depreciation assumptions were made by analysts reporting to the controller. 4) Operating projections were used to develop cash flow forecasts for NPV, IRR, and payback period calculations. These excluded non-cash items such as depreciation, and were computed on an after-corporate-tax basis, excluding financing charges. 5) Discount rates were assigned based on a subjective assessment of each projects risks made at the division level, but subject to review by the capital committee: High: 9% discount rate, Medium: 8.4% discount rate, Low: 7.7% discount rate 6) Projects including perpetuity returns were given a terminal value, with a low growth rate (lower than New Heritage growth and near-term growth for the division). No set guidance is provided here.

2) What one additional item of information not given in the case would you want to obtain before you make your decision? Why?

I would be interested in the terminal growth value for the Design your own doll (DYOD) project. Neither risk level nor terminal growth rate are provided, and both impact the valuation. A quick comparison shows that a 1% change in discount rate has a larger impact (see table 1 below); however, the growth rate is potentially more variable or open to interpretation by members of the divisions proposing the project, as outlined in the concerns raised in question 1. The terminal value of the DYOD project is especially important given its longer time horizon and larger up-front investment. Comparing the two projects using a similar, or fixed terminal growth rate is an option, as both projects include a terminal growth rate element, but it is much more important for the DYOD project. For both projects, I would also be interested to know how the terminal growth rate value is generated as, especially for Match My Doll Clothes (MMDC), there appears to be an element of fad or limited timeliness to them.

Table 1: Comparison of changes in discount rate and terminal growth rate NPV of Match My Doll Clothing (MMDC) Line Extension Discount 7.70% 8.40% 9.00% Terminal Value growth rate 0% 1% 2% 3% $ 5,300 $ 6,140 $ 7,290 $ 8,930 $ 4,400 $ 5,080 $ 5,950 $ 7,150 $ 3,760 $ 4,310 $ 5,020 $ 5,960 NPV of Design Your Own Doll (DYOD) product launch Discount 7.70% 8.40% 9.00% 0% $ 5,830 $ 4,400 $ 3,370 Terminal Value growth rate 1% 2% 3% $ 7,260 $ 9,200 $11,960 $ 5,530 $ 7,000 $ 9,020 $ 4,290 $ 5,480 $ 7,060

3) What one aspect of the decision faced by NHD that is discussed in the case but that is not reflected in the numbers is most important and should be taken into account separately from the NPV/IRR analysis? Might this extra item cause you to pick one alternative over the other despite the numbers in the case? The one item that is discussed in the case but not reflected or captured in the numbers is the level of risk, or the downside risk for each project. This would include internal factors such as the potential loss of reputation for poor implementation, external factors such as increased competition, and seasonality issues as most toy sales were quite seasonal and whether DYOD would help or exacerbate this problem. The lead of the DYOD project has not shared her estimation of the risk level for her project, and with good reason. The project has a high risk of damaging relationship or reputation with most valuable customers. While the DYOD project fits with the companys mandate and key success factors o f providing users with a unique doll experience, it requires a LOT of capital investment (double that of MMDC), demands many capabilities beyond that of New Heritage, i.e. relying on contractors, and has not been actually tested with a model of the technology. The value or financial contribution of sales resulting from these valuable, long -time customers should be included as a risk, especially given the risk of failure. In addition, this value could be used to look at potential cannibalization loss from the introduction of DYOD. Alternatively, additional considerations such as potential new entrants or increased competition in this increasingly competitive doll space, as well as the fact that so few lines lasted more than a few years, means that introducing new products such as DYOD, through new media such as the internet, might actually be a required move for the company. Such external factors should be included in the level of risk assumption. Finally, seasonality was mentioned as a continual issue for toy and doll makers. Being online and customizable could DYOD help or hurt this seasonality, and is an important consideration. The impact of this risk assessment would sway my decision over to the slightly more conservative, yet still positive NPV option of the MMDC project. A summary of capital evaluation metrics for each project is shown below.
Table 2: Comparing MMDC and DYOD projects: MMDC $7,150 7.6% 7.4 Base assumptions Terminal growth Discount rate 3% 8.4% 3% 9% DYOD $7,060 -0.5% >10

NPV IRR Payback (yrs)