The Capital Budgeting, Essay Example

The Role

For this simulation project I decided to go with Toddler Doll Accessory Line because they are one of the top 3 most profitable for the company throughout 2014. The role of each project within the company includes the five projects: Toddler Doll Accessory Line that costs 2.14 and has a low risk.

Product Division

Toddler Accessory Line: this project involves developing a new line of accessories-carriages, cribs, carriers for an existing New Heritage Doll toddler doll line (‘My First Baby and Accessories’). Its intended target market is a toddler.

Match my Doll Clothing Line: this project involves developing clothing accessories to mimic real-life situations in which the doll character might find herself. This is for all existing doll lines.

Retail Division

Retail Store expansion in Northeast: this project involves building of retail presence in the Northeast, particularly in the Carolinas, Georgia and Florida. All these retail stores are experiential destinations.

Licensing Division

New doll Film/DVD: this project involves licensing rights to New Heritage’s branded doll characters and story lines to a new doll movie or TV show.

The selected discount rate is the expected rate of return that is required on any and all New Heritage investments. This rate has factored in the cost of inflation and as such is a reflection of what is the fundamental return that is required from the projects.

The Rank of Projects

Based on the facts from the case study and the assumptions made about each project, the projects that can be ranked from best to work can be broken down into four different metrics;

• NPV
• IRR
• Payback Periods
• Profitability Index.

Reasonable Points of Difference

The new doll film project has the highest NPV and yet maintains the shortest payback period of 1.05 years. In 2009 the APV for Toddler Doll Accessory Line was 3.48, compared to 2014 were the project was less than 1.0

Unreasonable Points of Difference

The consolidation of warehouse project has the lowest IRR and NPV, a negative profitability index and has the third best payback period of 8.23 years. This is an unreasonable point of difference. The match my doll clothing line project has the second best NPV while has the worst payback period of 9.21 years and the second worst IRR and profitability index.

The Profitability Index

When summarizing this category the profitability index is essential in giving the company an insight to which project would be more profitable and which one will not. Over the simulation and the years as the profitability of each of the projects increase or decrease was the overall financial attractiveness of the projects. Of all the projects they all had a positive NPV, with a higher IRR, and differing profitability index. Ranked from best to work for profitability was first the:

• New Doll Film/DVD, Retail Store Expansion in Northwest,
• Toddler Doll Accessory Line,
• Match My Doll Clothing Line,
• The worst Warehouse Facility Consolidation.

Warehouse Facility Consolidation would be the project that would be eliminated and not proposed to the committee even through each year it did not increase in attractiveness while it had the lowest NPV, it also had the highest cost.

The profitability index is a very important accounting ratio in many aspects. Namely:

1. It puts into consideration the time value of money
2. It puts into consideration the analysis of all the cash flows for the entire life of the project
3. It does not consider the amount of money invested (scale of investment) into a project but rather gives an analysis of the cost and benefit relationship, depicting the ratio between the project’s present value over the value of the initial project
4. It determines the precise rate of return of any given project
5. It is essential in developing a ranking criteria to determine the order in which projects should be considered regardless of the initial amount of investment required

Good Performance funded Project Sets

In determining the good performance based on the simulation, the higher the IRR, the NPV, the Profit Index, and the lower the payback period would result in a project having a good performance. Left with the two valuable options of Match My Doll Clothing Line and Toddler Doll Accessory Line, the costs were high as was the EBIT and the Profitability Index, which meant they both perform well, with the two chosen to do the best.

Product Division

Toddler Accessory Line: with a 24.80% IRR and 3.19 profit index, this will be the third best performing project. This is notwithstanding the fact that the product division has the second highest revenue levels for NH and has the largest portion of its total assets.

Retail Division

Retail Store Expansion in the Northeast: with a 34.83% IRR and 6.43 profit index, this will be the second best performing project for NH. This is owing to the fact that the retail division has the second largest portion of NH’s total assets. This division also ranks in the highest revenue for NH.

Licensing Division

New doll Film/DVD: with a 239.61% IRR and 9.91 profit index, this will be the best performing project for NH. This is owing to the fact that the licensing division has the highest cash flows and operational profit.

Optimal Capital Budget

The capital budget is meant to show the maximized value of the company. For the value of each project the NPV should be positive if they are greater than 0, then they are at an optimal set. Comparing each simulation year, they differ in costs and future net incomes. The first simulation is the optimal set, with cost being lower and a higher future income than year 2, but lower compared to year 3. In choosing the optimal set, we would choose the Toddler Doll Accessory Line over Match My Doll Clothing line, because it has a lower risk than the latter, and while both can be a successful and profitable for the company, the Toddler Line can have better longevity. My decisions and the optimal set were not different as these three project record the highest IRR and is far above the discount rate. These three projects are also in line with current market trends and fashions.

With an available annual budget of 8.0, the optimal allocation of the budget would be:

The optimum budget allocation is based on the cost of initial investment against the IRR and profitability index. These two factors rank the best projects that need to be funded as they show which projects have the highest return on investment and also how profitable the project is on each unit of currency invested. The payback period has been ignored since the IRR and profitability index provide a much clearer picture of which projects are best funded. As is in the case of the consolidation of warehouse facility. This project has the third best payback period but yet has the worst IRR and NPV. Furthermore it has a negative profitability index.

The Proposals

Given the financial analysis of each projects the following assumptions can be made. The table provides the NPV of the two proposals that were given a discount rate of the low risk at 7.7%, the medium risk of 8.4%, and the high risk at 9.0%. Rated at 8.4% the Match My Doll Clothing line has medium risk cost of capital. With Emily’s experience in the industry this number is potentially the correct assumption, however, the company needs to take into consideration if the product line is in line with the core competencies of the company, and how the market has differed for dolls. In taking into consideration these factors it could mean a potentially higher risk than reported.

The last project funded is the consolidation of warehouse facility owing to the fact that it has the lowest profitability index and the highest requirement of initial investment. The project has a negative NPV, 0.62 ? 1. Therefore, even with a higher NPV alternative the project is not fundable.

For the project, Toddler Doll Accessories line it will automatically fall into a lower risk category in part because of the flexibility and the low production costs. The lack of reliance on newer manufacturing processes, and the lack of reliability of a flawless execution using the new web interface. This risks can potentially mitigated to a lower risk level (medium), if the fixed costs could be moderate, and the fact it plays to the strengths of the company by creating a memorable experience for the customers. The low level of risk are critical in the calculations of both proposed project that will include the terminal value assumed at a 3% rate of growth potential that is accordance with the sales projections for U.S retail dolls.  Match My Doll Clothing Line has gained previous success, and the company wants to expand on the product land. At the time the product line was a hit because young girls were able to identify with the dolls, because of the continued popularity of the dolls, the manager feels that this is the opportune time to expand on the success. This proposed expansion would mean clothing and gear for all seasons, and would provide more matching little girl for toddler girls.

In the case of Toddler Doll Accessory Line it is one of the lower risks with the low production cost. Ranked from higher to lower, the simulation of the Toddler Doll Accessory Line at 6.97, the Retail store expansion that has three stores that open which has high NPV, and the New Doll Film and DVD line with low risk as well. The Toddler Doll Accessory Line has shown to have a good performance, out of the three has the third highest NPV, IRR, and profit index, but costs the fourth smallest at 2.14. On the contrast the Match My Doll Line which is clear favorite because of its record of success that has the second highest cost, but a lower NPV than the Toddler Doll Accessory Line, and the second lowest IRR. In choosing which one would be profitable, they all would, but the Toddler Doll Accessory Line seems like the best option. The discount for production was 7.85% because it was considered a low risk project throughout the simulation.  In the financial analysis of the company the projections for operating where used in creating the cash flow forecast that were used to calculate the internal rates of return, the net present value, the profitability index, and the payback period. Based on their financial summaries they had a corporate tax rate of 40%, and cash flows did not include the regular financial charges or non-cash items.

In order to make an informed decision all these factors in capital budgeting is critical in determining the success of each project. Based on these facts and assumptions from the simulations, they project that Emily proposed to the committee should be the Toddler Doll Accessory Line it is almost tied with My Matching Doll Clothing Line, either of the two would do well for profitability for the company. Taken into account the Net Present Value, the Profitability Index and other factors the Toddler Project will be more profitable.