Corporate Finance Essay
1. Set forth and compare the business cases for each of the two projections under consideration by Emily Harris. Which do you regard as more compelling? Productions was New Heritage´s largest division as measured by total assets, and easily its most asset-Intensive. Approximately 75 % of the division´s sales were made to the company´s retailing division, with the remaining 25% comprising private label goods manufactured for other firms.
The division revenue figures include approximately $95 million of internal sales within divisions which are eliminated when considering consolidated revenue for the company. We must look closer on the financial projections and the operating details for the two proposals. By looking we can see a big difference in Revenue growth.
We realize that Design your own doll can handle much more additional annual revenue according to the resources in the balance sheet. According to the outlays the initial expenditures for Design Your Own Dolls is much higher than Match my Doll Clothing. As with Match my Doll Clothing the required R&D and marketing costs would be tax deductible. EBIT is a good gauge of how well those two companies is being managed. It is watched closely by all stakeholders, because it measures both overall demand for the company´s products and the company´s efficiency in delivering those products.
The operating projections tell us that Design Your Own Doll has gained more in operating profits. Substantial investment in working capital (primarily work in process inventory of partially manufactured dolls) would be required beginning in 2011 for Match My Doll Clothing to support the forecasted level of sales. The value of a risky alternative to the decision maker may be different than the expected value of the alternative because of the risk that the alternative poses of serious losses.
The concept of the certainty equivalent is useful for such situation. Factors considered in the assessment of a project´s risk for Emily Harris included, for example, whether it required new consumer acceptance or new technology, high levels of fixed costs and hence high breakeven production volumes, the sensitivity of price or volume to macroeconomic recession, the anticipated degree of price competition, and so forth. Given the proven success of Match My Doll Clothing, Harris believed the project entailed moderate risk that is, about the same degree of risk as the production division´s existing business as a whole.
Design Your Own Doll had a relatively long payback period, introduced some untested elements into the manufacturing process, and depended on near-flawless operation of new customer-facing software and user interfaces. If the project stumbled for some reason, New Heritage risked damaging relationships with the best customers. On the other hand, the project had a relatively modest fixed cost ratio, and it played to the company´s key strength – creating a unique experience for its consumers. The cash flows excluded all financing charges and non-cash items (i.e. depreciation), and were calculated on an after-corporate-tax basis. The New Heritage’s corporate tax rate is 40%. We think that the Design Your Own Doll project is more compelling.
2. Use the operating projections for each project to compute a NPV for each. Which project creates more value? (Please find the calculations in the attachment) NPV calculations include a terminal value computed as the value of a perpetuity growing at constant rate. We computed Free Cash Flows (FCF) to find out the actual amount of cash from operations that the company could use in developing its new projects.
We calculated the terminal value for 2020 as projected FCF in the first year beyond the projection horizon divided by discount rate of 8.4% less the perpetuity growth rate, which in this case was 3%. According to our calculations the MMDM’s terminal value in 2020 is 16,346,000 and DYOD’s is 27,486,000. Based on the our calculation the NPV of the Match My Doll Clothing project is $7,151,000 ( and the NPV of the Design Your Own Doll project is $9,257,000 . In both cases the NPV is greater than zero but NPV of project 2 is greater than NPV of project 1, therefore project number 2 should be selected. | | | | | | | | | | | |
NPV calculations for Design Your Own Doll| | | | | | | | | | | | | | | | | | | | | |
| 2010| 2011| 2012| 2013| 2014| 2015| 2016| 2017| 2018| 2019| 2020| EBIT | -1201,00| 0,00| 550,00| 1794,00| 2724,00| 2779,00| 2946,00| 3123,00| 3310,00| 3509,00| 3719,00| Tax @ 40% | -480,40| 0,00| 220,00| 717,60| 1089,60| 1111,60| 1178,40| 1249,20| 1324,00| 1403,60| 1487,60| | | | | | | | | | | | |
Net Income | -720,60| 0,00| 330,00| 1076,40| 1634,40| 1667,40| 1767,60| 1873,80| 1986,00| 2105,40| 2231,40| plus: depreciation | 0,00| 0,00| 310,00| 310,00| 310,00| 436,00| 462,00| 490,00| 520,00| 551,00| 584,00| less: ΔNWC | 0,00| 1000,00| 24,00| 1386,00| 942,00| 202,00| 213,00| 226,00| 240,00| 254,00| 269,00| less: capital expenditures | 4610,00| 0,00| 310,00| 310,00| 2192,00| 826,00| 875,00| 928,00| 983,00| 1043,00| 1105,00| | | | | | | | | | | | |
Free Cash Flow (FCF) | -5330,60| -1000,00| 306,00| -309,60| -1189,60| 1075,40| 1141,60| 1209,80| 1283,00| 1359,40| 1441,40| terminal value | 0,00| 0,00| 0,00| 0,00| 0,00| 0,00| 0,00| 0,00| 0,00| 0,00| 27486,00| FCF after terminal value | -5330,60| -1000,00| 306,00| -309,60| -1189,60| 1075,40| 1141,60| 1209,80| 1283,00| 1359,40| 28927,40| | | | | | | | | | | | |
Discount factor (DF=8,4%) | 1,00| 0,92| 0,85| 0,79| 0,72| 0,67| 0,62| 0,57| 0,52| 0,48| 0,45| | | | | | | | | | | | |
Present Value (PV) | -5330,60| -922,20| 260,41| -243,07| -861,51| 718,47| 703,57| 687,77| 672,93| 657,81| 12913,19| | | | | | | | | | | | |
Cumulative Present Value| 14587,38| | | | | | | | | | | Net present value (NPV)| 9256,78| | | | | | | | | | |
3. Compute the IRR and payback period for each project. How should these metrics affect Harris´s deliberations? How do they compare to NPV as tools for evaluating projects? When and how would you use each? IRR Analysis
Table – IRR Sensitivity Analysis |
Revenue Change | Match My Doll Clothing Line | Design Your Own Doll (baseline) 3% | 18.24% | 14.68% |
2% | 17.74% | 14.28% |
1% | 17.24% | 13.87% |
0% | 16.74% | 13.46% |
-1% | 16.23% | 13.04% |
-2% | 15.72% | 12.62% |
-3% | 15.21% | 12.19% |
-4% | 14.69% | 11.77% |
-5% | 14.16% | 11.33% |
-6% | 13.63% | 10.90% |
The model reflects a change in revenue from +3% to -6%.
IRR of NPV is not used because sensitivity is included in the discount rate. Payback Period Analysis
Payback period for each of the scenarios:
* Match My Doll Clothing Line Expansion (baseline) = 8.43 years * Design Your Own Doll (baseline) = 10.09 years
4. What additional information does Harris need to complete her analyses and compare the two projects? What specific questions should she ask each of the project sponsors? In order to complete her analyses, several questions need to be asked in order for the report to be as fruitful as possible.
Thus the questions that could be asked in order for Harris to make good decisions in comparing the two projects, goes as follows. * What changes would be expected in capital expenditures during periods of change? * Are there any hidden labor costs not being considered in the Match My Doll Clothing Line Expansion, similar to the additional labor costs in Design Your Own Doll? * What level of risk does the project Design Your Own Doll pertains?
In hand with revenue-analysis, what are the incremental earnings? * In addition to the risk level of Design Your Own Doll, is the project stable enough not to harm customer relationships? * What is the forecast for the whole industry? What will be the future market share since this affects sales outstanding and in hand revenue? * Based on the data, what will the equity of the company and share price be, taking into account the two projects? Historical data for inventory turnover ratios; days sales outstanding and days payable outstanding would also be additional information that Harris could benefit from.
5. If Harris is forced to recommend one project over the other, which should be recommended? Why? To improve the present value for both projects the management of the company should think of how to improve the projects’ cash flows. Typically, companies aim to increase cash flow from their existing operations by collecting receivables as soon as possible and slowing down their payables without harming their relations with suppliers. The NPV is a forecast, and as with every forecast, the outcome is not given. Typically forecasts for shorter periods are more accurate.
The forecast for New Heritage Company is based on a time period of 10 years. I would recommend reducing that time period to provide more accurate cash flow figures. As with all forecasts, the NVP is not free from risks. The management should be aware that risks such as increase in inflation, change in interest rates, and increased competition in the toys business, could have a negative impact on future benefits of selected project.
Last, I would recommend for the management to monitor the costs to increase profits. However, the management should weigh the benefits of reducing costs to avoid an adverse effect of diminished profits. If additional cash inflows are achieved, the company should invest a portion of the profits to generate additional money and expand the business through creation of new products and projects.