READ THIS FIRST
Case New Heritage Doll Company
USE TAB Q1 IN THIS EXCEL FILE TO ANSWER THE QUESTIONS. TYPE DIRECTLY INTO THE BOXES PROVIDED. SAVE AS: YOUR NAME NEW HERITAGE
Learning Objectives
You will learn the three steps in capital budgeting:
1 Identify relevant incremental cash flows
2 Calculate cost of capital (k-wacc) to use as the discount rate
3 Calculate the metrics of capital budgeting: Net Present Value, Profitability Index,
Internal Rate of Return, and Payback Period.
Then, you will apply the metrics and information in the case study to make a recommendation
about which of the two projects to accept.
The essence of the capital budgeting process is to make sure, before an investment is made,
that its prospective rate of return is high enough to justify the investment.
Reading Cohen finance book chapter 4 is a review of Time Value of Money, which you covered in a previous course, probably more than once.
Review it as necessary, but defer the review until you look at the TVM applications in chapter 5 beginning on p 79, and in the case exhibits.
You need to know TVM to understand the capital budgeting metrics of NPV, PI, and IRR. Make sure you
have that context in mind before reviewing the TVM chapter 4 (only if you need to).
Read the Heritage Doll Company case, focussing first on the two case exhibits, shown in the Ex. 1 and Ex. 2 tabs.
Study the completed analysis in Ex. 1-MMDC
Then complete the analysis in Ex. 2-DYOD following the MMDC example.
With all decision metrics in hand, prepare to make the recommendation as requested in the Q1 Recommendations tab, by considering
the facts and opinions in the case IN ADDITION to the decision metrics.
Read Cohen finance book chapter 5 selectively. Focus on:
See the FLOW DIAGRAM in GREEN depicting the CAPITAL BUDGETING template.
See the IS/BS Model in GREEN depicting the connection between PPE (BS) and operating expense (IS).
Read about weighted average cost of capital.
Read about Net Working Capital.
Read about NPV, PI, IRR, PP.
Study the Generic Capital Budgeting Template.
Realize that both the Generic Capital Budgeting Template and the New Heritage case exhibits are very similar -
they are both constructed to calculate FREE CASH FLOW=EBIT-TAX+DEPREC+/-CHANGE NWC+/-CAPEX.
Flow Diagram
THUMBNAIL SKETCH: FINANCING DEBT EQUITY
BRIEF ANALYSIS DEBT
DUPONT RATIOS HISTORICAL RATIOS I/S & B/S FORECAST EFN
TIE
NORMAL DEBT RATIO WORKING CAPITAL I/S, B/S, & RATIOS EQUITY
STOCK PRICE EBIT CHART
MKT CAP
EXTENDED ANALYSIS
FULL RATIOS
LIQUIDITY income risk control mktblty flexblty timing
LEVERAGE
ASSET USE
PROFITABILITY
VALUATION
GROWTH CAPITAL BUDGETING OP & CAP NATCF, NPV, IRR, PAYBACK
ANALYSIS STEPS:
1-HISTORICAL RATIOS
2-K-WACC
3-CAPITAL BUDGETING
4-FORECAST & EFN K-WACC
5-EQUITY VALUATION
6-FINANCING
VALUATION ENTERPRISE VALUE USING FREE CASH FLOW
MARKET MULTIPLES: P/E, MV/BV, REV, EBIT
IS-BS Model
INCOME STATEMENT XXXXXXXXXXBALANCE SHEET WORKING CAPITAL
Revenue ASSETS LIABILITIES AND EQUITY changes spontaneously with revenue
Cost of sales Cu
ent assets Cu
ent liabilities ?what levels of ca, cl, s-t loans?
Gross profit Cash Trade payables CAPITAL BUDGETING
Other operating income Investments Other accruals ?which projects to accept?
Other operating expenses Trade receivables Tax liabilities FINANCING
Total cost and expenses Inventories Short-term loans, leases ?how much debt capacity?
Operating profit (EBIT) Non-cu
ent assets Non-cu
ent liabilities
Interest, finance costs Property, plant & equipment Loans, debt, leases due after 1 yea
Profit before tax Investment property Retirement benefit obligation COST OF DEBT
Income tax Goodwill Defe
ed tax liabilities
Net profit after tax Total non-cu
ent liabilities
Dividends XXXXXXXXXXK-WACC
Reinvested in the business Stockholder's equity (Net worth)
Prefe
ed stock
OPERATING LEVERAGE Common stock COST OF EQUITY
Additional paid-in-capital
FINANCIAL LEVERAGE Retained earnings VALUATION
CASH FLOW
Total assets Total liabilities & equity COST OF CAPITAL
Ex. 1-MMDC
New Heritage Doll Company: Capital Budgeting
Exhibit 1
MMDC
2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Revenue 4,500 6,860 8,409 9,082 9,808 10,593 11,440 12,355 13,344 14,411
Revenue Growth NA 52.4% 22.6% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0%
Production Costs
Fixed Production Expense (excl depreciation) 575 575 587 598 610 622 635 648 660 674
Variable Production Costs 2,035 3,404 4,291 4,669 5,078 5,521 6,000 6,519 7,079 7,685
Depreciation 152 152 152 152 164 178 192 207 224 242
Total Production Costs 0 2,762 4,131 5,029 5,419 5,853 6,321 6,827 7,373 7,963 8,600
Selling, General & Administrative 1,250 1,155 1,735 2,102 2,270 2,452 2,648 2,860 3,089 3,336 3,603
Total Operating Expenses 1,250 3,917 5,866 7,132 7,690 8,305 8,969 9,687 10,462 11,299 12,203
Operating Profit (1,250) 583 994 1,277 1,392 1,503 1,623 1,753 1,893 2,045 2,209
Operating Profit/Sales 0.130 0.145 0.152 0.153 0.153 0.153 0.153 0.153 0.153 0.153
SG&A/Sales 0.257 0.253 0.250 0.250 0.250 0.250 0.250 0.250 0.250 0.250
Working Capital Assumptions:
Minimum Cash Balance as % of Sales NA 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0%
Days Sales Outstanding NA 59.2x 59.2x 59.2x 59.2x 59.2x 59.2x 59.2x 59.2x 59.2x 59.2x
Inventory Turnover (prod. cost/ending inv.) NA 7.7x 8.3x 12.7x 12.7x 12.7x 12.7x 12.7x 12.7x 12.7x 12.7x
Days Payable Outstanding (based on tot. op. exp.) 0.0x 30.8x 30.9x 31.0x 31.0x 31.0x 31.0x 31.0x 31.0x 31.0x 31.0x
Capital Expenditures 1,470 952 152 152 334 361 389 421 454 491 530
Growth in capex -35.2% -84.0% 0.0% 119.3% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0%
Net Working Capital Accounts 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Cash 135 206 252 272 294 318 343 371 400 432
Accounts Receivable 729 1112 1363 1472 1590 1717 1855 2003 2163 2336
Inventory 360 500 396 427 461 498 538 581 627 677
Accounts Payable 317 484 593 640 692 747 807 871 941 1016
Net Working Capital 800 907 1334 1418 1531 1653 1786 1929 2083 2250 2429
DNWC 107 427 84 113 122 132 143 154 167 180
NWC/Sales 0.202 0.195 0.169 0.169 0.169 0.169 0.169 0.169 0.169 0.169
NPV Analysis
Free Cash Flows 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
EBIT(1-t) (750) 350 596 766 835 902 974 1,052 1,136 1,227 1,325
plus depreciation 0 152 152 152 152 164 178 192 207 224 242
less DNWC (107) (427) (84) (113) (122) (132) (143) (154) (167) (180)
less capital expenditures (952) (152) (152) (334) (361) (389) (421) (454) (491) (530)
Free Cash Flow (750) (557) 169 682 541 583 630 680 735 793 857
Terminal value 3.00% 16,345
Initial Outlays
Net working capital (800)
Net property, plant & equipment (1470)
Discount factor 8.40% 1.0000 0.9225 0.8510 0.7851 0.7242 0.6681 0.6163 0.5686 0.5245 0.4839 0.4464
Present value (3,020) (514) 144 536 392 390 388 387 385 384 7679
Net Present Value $ 7,150
NPV without Terminal Value $ (146)
IRR Analysis
2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Cash Flows (3,020) (557) 169 682 541 583 630 680 735 793 17,202
IRR 24.0%
Payback Analysis
2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Cash flows (3,020) (557) 169 682 541 583 630 680 735 793 17,202
Cumulative cash flow (3,020) (3,577) (3,408) (2,726) (2,185) (1,602) (972) (291) 443
Payback period 7.40 years
5-year Cumulative EBITDA $ 6,522
Profitability Index
NPV/Initial Investment 2.37
Ex, 2-DYOD
New Heritage Doll Company: Capital Budgeting
Exhibit 2
DYOD
2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Revenue 0 6,000 14,360 20,222 21,435 22,721 24,084 25,529 27,061 28,685
Revenue Growth NA 139.3% 40.8% 6.0% 6.0% 6.0% 6.0% 6.0% 6.0%
Production Costs
Fixed Production Expense (excl depreciation) 0 1,650 1,683 1,717 1,751 1,786 1,822 1,858 1,895 1,933
Additional development costs (IT personnel) 435
Variable Production Costs 0 2,250 7,651 11,427 12,182 12,983 13,833 14,736 15,694 16,712
Depreciation 0 310 310 310 436 462 490 520 551 584
Total Production Costs 0 435 4,210 9,644 13,454 14,369 15,231 16,145 17,113 18,140 19,229
Selling, General & Administrative 1,201 0 1,240 2,922 4,044 4,287 4,544 4,817 5,106 5,412 5,737
Total Operating Expenses 1,201 435 5,450 12,566 17,498 18,656 19,775 20,962 22,219 23,553 24,966
Operating Profit (1,201) (435) 550 1,794 2,724 2,779 2,946 3,123 3,310 3,508 3,719
Operating Profit/Sales 0.092 0.125 0.135 0.130 0.130 0.130 0.130 0.130 0.130
SG&A/Sales 0.207 0.203 0.200 0.200 0.200 0.200 0.200 0.200 0.200
Working Capital Assumptions:
Minimum Cash Balance as % of Sales NA NA 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0%
Days Sales Outstanding NA NA 59.2x 59.2x 59.2x 59.2x 59.2x 59.2x 59.2x 59.2x 59.2x
Inventory Turnover (prod. cost/ending inv.) NA NA 12.2x 12.3x 12.6x 12.7x 12.7x 12.7x 12.7x 12.7x 12.7x
Days Payable Outstanding (based on tot. op. exp.) NA NA 33.7x 33.8x 33.9x 33.9x 33.9x 33.9x 33.9x 33.9x 33.9x
Capital Expenditures 4,610 0 310 310 2,192 826 875 928 983 1,043 1,105
Growth in capex 0% 608% -62% 6% 6% 6% 6% 6%
Net Working Capital Accounts 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Cash
Accounts Receivable
Inventory
Accounts Payable
Net Working Capital
DNWC
NWC/Sales
NPV Analysis
2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Free Cash Flows
EBIT(1-t)
plus depreciation
less DNWC
less capital expenditures
Free Cash Flow
Terminal value
Discount factor
Present value
Net Present Value
NPV without Terminal Value
IRR Analysis
2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Cash Flows
IRR
Payback Analysis
2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Cash flows
Cumulative cash flow
Payback period
5-year Cumulative EBITDA
Profitability Index
NPV/Initial Investment
The input data are provided in rows 4-28 above.
Use the Ex. 1- MMDC example to complete the DYOD analysis.
Q1-Recommendations
Q1a
Briefly present the business cases for each project. Which one is the most compelling and why?
Q1
How do the capital budgeting metrics you calculated in Q1 and Q2 influence Emily's deliberations?
Which project creates more value for Heritage Doll Company?
Q1c
Does Emily need additional information to complete her analysis, and if so,
what questions should she put to the sponsors of each prioject.
Q1d
As Emily, using the information you have and your professional judgment, make the recommendation and justify it.
New Heritage Doll Company: Capital Budgeting
________________________________________________________________________________________________________________
HBS Professor Timothy Luehrman and HBS MBA Heide Abelli prepared this case solely as a basis for class discussion and not as an
endorsement, a source of primary data, or an illustration of effective or ineffective management. This case, though based on real events, is
fictionalized, and any resemblance to actual persons or entities is coincidental. There are occasional references to actual companies in the
na
ation.
Copyright © 2010 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call XXXXXXXXXX,
write Harvard Business Publishing, Boston, MA 02163, or go to http:
www.hbsp.harvard.edu. This publication may not be digitized,
photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School.
T I M O T H Y L U E H R M A N
H E I D E A B E L L I
New Heritage Doll Company:
Capital Budgeting
In mid-September of 2010, Emily Ha
is, vice president of New Heritage Doll Company’s
production division, was weighing project proposals for the company’s upcoming capital budgeting
meetings in October. Two proposals stood out based on their potential to strengthen the division’s
innovative product lines and drive future growth. However, due to constraints on financial and
managerial resources, Ha
is knew it was possible that the firm’s capital budgeting committee would
decline to approve both projects. She also knew that New Heritage’s licensing and retail divisions
would promote compelling projects of their own. Consequently, Ha
is had to be prepared to
ecommend one of her projects over the other.
The Doll Industry
Revenues in the U.S. toy and game industry totaled $42 billion in 2008 and were projected to
increase by 4.6% per year to $52.5 billion by XXXXXXXXXXThe market was divided into two
oad segments:
video games (48%) and traditional toys and games (52%). The second segment was further divided
into infant/preschool toys (14.5%), dolls (14.1%), outdoor & sports toys (12.3%), and other toys &
games (59.1%) including arts and crafts, plush toys, action figures, vehicles, and youth electronics.
The U.S. market for toys and games was dominated by large global enterprises that enjoyed
economies