New Heritage Doll Case Lauren Knausenberger 1. Which of the two projects create more value? In order to determine which of the two projects create more value, we must calculate NPV based on the assumptions relevant to the decision. The table below shows the NPV for the two product lines given discount rates of 7. 7% (low risk), 8. 4% (medium risk), and 9. 0% (high risk).
The Match My Doll Clothing line is currently rated as a medium risk project with 8. 4% cost of capital. Given Emily’s knowledge of the industry we may be able to accept this; however, the firm should also consider whether children’s clothing lies within their core competencies and how different the market is from their current market for dolls. These factors could raise the risk rating to high.
The Design your Doll project most likely falls into the high risk category due to the long payback period, new manufacturing processes, and reliance on flawless execution through a new web interface; however, the risk is potentially mitigated to the medium level due to the moderate fixed costs and the fact that it plays to the company’s key strength – creating a unique experience for consumers.
Calculations for both projects include the terminal value assuming a 3% rate of perpetual growth, in line with the growth projections for US retail sales of dolls, and the growth of the US economy in general. |Calculations |Match My Doll Clothing |Design Your Own Doll | |NPV @ 7. 7% (including TV) |$11,104 |$15,788 | |NPV @ 8. 4% (including TV) |$9,122 |$12,537 | |NPV @ 9. % (including TV) |$7,446 |$10,378 | |IRR |32% |23% | |Payback Period |6 |9 | Emily Harris is faced with a limited budget and must justify and choose the project that creates the most value. That is, she should select the project that has the higher NPV, since NPV is a measure of how much value is created over the lifetime of the analysis.
The Design Your Own Doll product creates more value when comparing the estimated project risk levels of 8. 4% and 9% respectively. It also creates more value for all scenarios considered except for the case where Match My Doll is taken at low risk and Design your Own taken at high risk. This situation is not realistic since each project is at least medium risk. Therefore, assuming the underlying data is sound, Design Your Own Doll line creates the most value and should be selected. New Heritage also often uses IRR to make projects decisions. IRR is included in the table above but should be considered with caution for the following reasons.
First, it forces the company to accept its preference for getting cash now rather than allowing them to influence that through its assumptions. Second, the decision rule changes depending on whether a firm is undertaking a borrowing or lending project; that is, the direction of the profile is reversed for borrowing projects and a lower IRR is optimal. Third, it has reinvestment assumptions built in that may be unreasonable. Further, there is a possibility of more than one IRR for a given project if there are cash outflows after the first period.
Finally, IRR is a measure of how efficiently capital is invested without regard to how much. On the other hand, NPV measure the value created and takes the amount into account. Thus, it is a more appropriate measure for this analysis. Emily also needs to consider the long-term strategy of the firm and whether these products are in line with the goals, brand image, and other considerations. Do they align with the firm’s core competencies and can they be successful in delivering, or are there operational complexities that make execution difficult or impossible.
They must also consider payback period depending on what their upcoming capital needs will be and what the opportunity costs are for the products. For instance, there is opportunity cost for the corporate resources used creating Design Your Own Doll. Most importantly, the committee needs to strongly consider where the numbers came from. Who put them together and what is their potential bias or motivation? The committee could look at past results to gauge this somewhat. If a manager has consistently overinflated revenue and under-projected cost chances are that same tactic is at play here.
The more they want to push an agenda the more incentive they have to be optimistic about the numbers. The committee should challenge the numbers and accept them only if there is strong data to back up the projections, such as independent market research and reasonable growth rates based on past performance, current market conditions, and anticipated future growth rates. Any of the inputs can drastically affect NPV and change which project appears to create more value. 2. What additional information does Harris Need in order to make a decision?
First, Harris needs to carefully scrutinize the numbers and make sure she has projections for the revenue growth and costs that are as un-biased as possible. Who did the analysis and what is their motivation? Have they been accurate in the past, or do they have a history of padding their numbers to get a product approved or to increase their bonus once they deliver greater than expected results? She may want to start by questioning the 8% and 6% projected growth rates for the products given the 3% growth of the US doll market.
What is it about these products that can deliver that rate of growth and what evidence backs it up? For the childrens clothing market, the case does not provide any data for growth. Are the growth numbers for the Match series based on doll sales, childrens clothing, or a combination thereof? Emily needs to know and she should carefully consider what data is most relevant here. Next, Emily should run a sensitivity analysis to determine value added using various growth rates. What growth rate do we need to break even and is that probable/realistic?
At what growth rates respectively does the Design project create more value than the Match project, and vice versa. She also needs to determine how sensitive each option is to shortfalls. The marketing folks should provide input to this discussion as well regarding the basics of the potential marketing strategy. That is, the 4 Ps and 5 Cs. Pricing will make a big difference on revenue and they need to have a good idea of what consumers are willing to pay for the products, what the competition is doing, and the breakeven sales volumes for each product.
They also need to look at distribution; which channels will they use, how much will it cost, will it require new relationships, and will it damage any current distributor relationships. Finally, how do they think introduction of this product will affect current product lines. What is the cannibalization rate and is it worth it? This information should all be included in the financial analysis. Emily should also carefully consider operational/execution risk. The Design Your Own Doll product requires near-perfect operation of a new customer GUI.
Has New Heritage ever built a software interface for their customers? Is this something they can do well? Do they do it in-house or outsource and has this been factored into the model? They need to ensure they have a proper strategy in place for roll out and the right people in charge of the execution to make sure the project succeeds. All of the above will greatly affect the inputs to the NPV calculation and thus should be closely scrutinized. After all, the quality of the NPV is only as strong as the quality of the assumptions upon which it is calculated.