New Heritage Doll Company

Case Study:

New Heritage Doll Company

Prefix – Capital Budgeting

T

he cash flows generated by each project are forecasted by making use of management guidance. It is important to note that this ‘base case’ is not adjusted upwards or downwards in order to reflect differing operating scenarios and therefore the valuation produces two specific values as opposed to two value ranges dependent on different scenarios. The rates used to discount the cash flows reflect the unique risk characteristics of each project in order to achieve an unbiased valuation reflecting the true opportunity cost of capital. The Match My Doll Clothing Line expansion (MMDC) is assumed to bear medium risk, corresponding to a project cost of capital of 8.40%, while Design Your Own Doll (DYOD) is assumed to be of high risk, corresponding to a project cost of capital of 9.00%. Each project is assumed to continue to exist and grow until infinity after the end of the ten-years-spanning projection period. The perpetuity growth rate of the terminal cash flows is assumed to equal 3.00%, which corresponds to the projected annual growth rate of the US retail sales within the toy and game industry between 2008 and 2013. This terminal value growth rate exceeds the current US inflation rate and also the growth in US GDP in 2016, but is certainly lower than the projected annual increase in revenues within the US toy and game industry between 2008 and 2013.

Question A: Which project creates more value?

The valuation analysis concludes that MMDC’s NPV amounts to US$ 7,207, while DYODs NPV amounts to US$ 7,411, indicating that, taking into account the specific risk characteristics of each project as well as the concept of time value of money, DYOD creates more value than MMDC.

Question B: Which project creates more value?

To understand the implications of the applied valuation technique, it is imperative to get a grasp of the assumptions embedded within the calculations. These assumptions, excluding explicitly formulated management assumptions, e.g. projected to sales growth, DSO, DIO and DPO figures, etc., include:

• The risk for each project is known and each project can be assigned to a pre-defined risk category (low: 7.70% - medium: 8.40% - high: 9.00%); furthermore, the risk profiles of the projects stay constant over their whole lifecycles.
• Tax advantages resulting from negative taxable income are immediately realized in the year that they occur and contribute positively to a project’s net present value as the company is profitable on a consolidated basis
• Both projects reach steady state after ten years, implying that the majority of the anticpated synergies is realized and potential integration efforts are completed within this time span; after reaching steady state, cash flows will grow at a constant rate until infinity
• After reaching steady state, the projects’ long-term growth rates correspond to the long- term retail revenue growth rate of the toy and game sector
• The projects do not contain additional real options, e.g. changing, expanding or curtai- ling the projects

Of these assumptions, several are up to challenge.

One such assumption is concerned with the discount rates of the respective cash flows. Assuming specific discount rates for each project and therefore not considering varying operating scenarios is highly questionable. The intrinsic valuation performed on the projects would imply that specific values can be assigned to each project and therefore ignore any uncertainties associated with the project cost of capital. However, it is imperative to account for this fact by producing value ranges.

The results of a sensitivity analysis performed on the projects to account for varying discount (c.p.) rates are shown in Exhibit 1. It is important to note that, when looking at the Exhibit, each project value should be observed individually. Comparing the value generation of each project at a certain discount rate can yield wrong conclusions, as the projects bear different risks and therefore, DYOD’s cash flows contain higher risk premia than MMDC’s cash flows. By comparing both projects at a discount rate of e.g. 8.40%, it is implied that, even though DYOD bears higher risk, its opportunity cost of capital are the same as for MMDC, a misevaluation that would lead to arbitrage in an efficient capital market. Because DYOD is riskier than MMDC, a higher discount rate needs to be applied to the former project to arrive at the same NPV.

Another questionable assumption relates to the terminal growth rates of the projects. This assumption is even more crucial when considering the fact that, for both projects and especially for DYOD, terminal value makes up for the most of NPV.

The results of a sensitivity analysis performed on the projects to account for varying terminal growth rates (c.p.) are shown in Exhibit 2. As the projects’ costs of capital are kept constant at their respective levels and the riskiness of each project is correctly accounted for, the charts can be directly compared to each other. Since DYOD’s NPV relies heavier on terminal value, that is, on cash flows far in the future, MMDC dominates DYOD for growth rates lower than 2.20% (c.p.), while DYOD dominates MMDC for growth rates higher than 2.20% (c.p.).