New Heritage Doll Company is a firm into the production of dolls which want to expand its brand to a broader market, by doing this they hope to capitalize on customer loyalty to maximize profit. Vice President Emily Harris is looking to forward her proposal to the budgeting committee for evaluation, she is presented with two viable option to strengthen the division product lines. The first project is Matching My Doll Clothing Line Expansion (MMDC), this would extend the warm weather products of the doll clothing line. The other project is Design Your Own Doll (DYOD), this would include a website where customers can choose the doll’s features, color etc. The firm has to choose which of the two project that most lucrative due to managerial and financial constraints.
Companies defined Capital Budgeting as the process used to determine whether capital assets are worth investing in. Capital assets are generally only a small portion of a company’s total assets, but they are usually long-term investments like new equipment, facilities and software upgrades (2017, August). Methods use to evaluate a project are Internal Rate of Return (IRR) calculation is used to determine whether a particular investment is worthwhile by assessing the interest that should be yielded over the course of a capital investment. The internal rate of return measurement is similar to the net present value metric (another capital budgeting method); however, the internal rate of return is formulated to make the net present value of all cash flows in a project equal to zero. It is for this reason that companies shouldn’t rely solely on the internal rate of return calculation to project profitability of a project and should use it in conjunction with at least one other budgeting metric, like net present value (2017, August). Net Present Value (NPV) is used for the same purpose as the internal rate of return, analyzing the projected returns for a potential investment or project. The net present value represents the difference between the current value of money flowing into the project and the current value of money being spent. But the industry must still recognize the potential room for error that arises when relying on calculations like investment costs, rates of discount, and projected returns, all of which rely heavily on assumptions and estimates (August, 2017). Profitability Index is a capital budgeting tool designed to identify the relationship between the cost of a proposed investment and the benefits that could be produced if the venture was successful. The profitability index employs a ratio that consists of the present value of future cash flows over the initial investment. As this ratio increases beyond 1.0, the proposed investment becomes more desirable to companies. However, the caveat to using the profitability index for capital budgeting is that the technique does not account for the size of a project; therefore, sizable projects with significantly large cash flow figures often claim lower profitability indexes because of their slimmer profit margins. But it does give the exact rate of return for a project of investment, which can be beneficial in understanding the cost-benefit of a project much easier. Accounting Rate of Return (ARR) is the projected return that a company can expect from a proposed capital investment. To discover the accounting rate of return, you must divide the average profit by the initial investment. However, accounting rate of return metric also has some minor drawbacks when used as the sole method for capital budgeting. The first drawback is that it does not account for the time value of the money involved meaning that future returns may be worth significantly less than the returns currently being taken in. And the second issue with relying solely on the accounting rate of return in capital budgeting is the lack of acknowledgement of cash flows. Pay Back Period is a unique capital budgeting method. Specifically, the payback period is a financial analytical tool that defines the length of time necessary to earn back money that has been invested. As with each method mentioned so far, the payback period does have its limitations, such as not accounting for the time value of money, risk factors, financing concerns or the opportunity cost of an investment. Therefore, using the payback period in combination with other capital budgeting methods is far more reliable. And finally, Weight average cost of capital (WACC) is used as the discount rate applied to future cash flows for deriving a business’s net present value. Investors use WACC as a tool to decide whether to invest. The WACC represents the minimum rate of return at which a company produces value for its investors (McClure, B. 2019). The method that’s more meaningful to my particular company is the NPV, IRR, payback period and discount rate.
The expansion of MMDC project is a medium risk project because it’s an extension of the existing product line. This project would have a discount factor of 8.40% which could calculate an NPV of $7,150.07 including terminal value and negative $146.20 not including terminal value. While DYOD project is of a higher risk because it’s based on a whole new product line and requires innovative technology component, this give the project a discount factor of 9.00%. the NPV for DYOD’s is $7,058.65 which include a terminal factor and a negative $3,390.88 without the terminal. Both projects have a positive NPV and would create value for the company on a whole. But, MMDC expansion project has a better and higher NPV, so in reality it would maximize more profit for the company. On the other hand, the internal rate of return (IRR) for MMDC expansion is 23.99% with terminal value and 7.64% without it included. IRR for DYOD is 17.88% with terminal and negative 0.52% without it included. Furthermore, MMDC has a payback period of 7.40 years while DYOD had a payback period of 9.07 years. Analyzing both projects shows an above assigned discount rate, MMDC has a 8.4% rate and DYOD is riskier with 9%. While DYOD could potentially generate higher revenue in the future, this project would take longer to generate free cash flow compare to MMDC. Even though the payback period is less of an effective tool than the IRR or NPV, it should be used in conjunction to both IRR and NPV to make a more inform decision.
From the analysis capital budgeting decision base on NPV analysis between the two alternatives for the New Heritage Doll Company. And since the NPV and IRR are higher in case of extension of My Doll Clothing line, the Company should consider the extension of My Doll Clothing Line. However, Design Your Own Doll (DYOB) seems to be a more sustainable project them MMDC. I forecast MMDC costs will increase and profitability decrease in the long run. On the other hand, DYOB’s profitability will increase in the long run. I feel a product line that allows customers to create a doll that resembles or aligns with them is a more viable option compared to New Heritage to come out with matching outfits which takes away from the company core value. I would recommend DYOB because it is more attractive, more sustainable in the long run, more in line with the company core values fostering individuality/customizations and focuses on the current loyal customers.
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McClure, B. (2019, May 21). Investors Need a Good WACC. Retrieved from https://www.investopedia.com/articles/fundamental/03/061103.asp#targetText=For instance, in discounted cash,a business’s net present value.&targetText=Investors use WACC as a,produces value for its investors.