Accouting & Valuation - Compute an Npv for the Project

1. Compute an NPV for each project. Which project creates more value?

Based on the NPV calculations in Appendix 1, Design Your Own Doll (DYOD) generates the highest NPV ($6,762,221.79) and thus creates the most value.

2. Based on the discussion in the case study, which assumptions is most open to challenge? Illustrate the sensitivity to these assumptions.

The assumption most open to challenge is the growth rate followed by the discount rate. Referring to Appendix 1 it is clear that the perpetual growth rate has a significant influence on the projects NPV outcome, hence it is an important factor in estimating the values of each project. Small changes in the perpetual growth rate create significant changes as e.g. a +0.25% change for DYOD equals a +6.7% increase in the NPV (see Appendix 2) and likewise a +3.8% increase in the NPV for Match MY Dolls Clothing (MMDC) (see Appendix 3). These significant changes reflect a high degree of volatility caused by uncertainty, as external factors may influence the underlying assumptions and the outcome over time. Despite the amount of uncertainty, it is stated that New Heritage Doll Company’s capital committee possess a great degree of conservatism when it comes to perpetual growth rates. Therefore, the assumptions do not exceed the projected market growth of 3% for dolls in the US. MMDC is an expansion of an existing product line and is expected to experience a higher immediate growth rate than DYOD, however it is assumed to slow down in the long term, as lasting franchise value for a branded line of dolls is rare (Brief Case, HBS, p. 1). Additionally, the DYOD is based on new technology and introduces a new product to the market. Market research showed enthusiasm for the product concept, hence it is assumed to experience a positive long-term potential and therefore a higher perpetual growth rate. Summarising the elements, it has led to positive growth rates for both projects just below the market rate, however the DYOD has a slightly higher growth rate than MMDC, as the long-term projections are assumed to last longer for DYOD than for MMDC.

Both projects contain a degree of risk, reflected in the discount rate. As the discount rate is used to discount all future cashflows back to present value, it has a significant influence on the NPV and thereto the decision on which project to undertake. In this case, the discount rate is supplemented by New Heritage Doll Company’s risk definitions (low, medium, high), which for MMDC is medium (Brief Case, HBS, p. 5). Therefore, it will be assessed at an 8.4% discount rate. On the other hand, the DYOD project requires new consumer acceptance and has a high level of fixed costs (Appendix 1). In addition, the initial investment required for this project is almost double the size compared to the MMDC project, which results in a longer payback period and a higher break-even point. Finally, since the project needs the modification of existing technology and webhosting capacity, the product will sell at a premium to cover the costs, and at the same time it will make the product more sensitive to a macroeconomic recession. Therefore, the DYOD is rated as a high-risk project and a 9.00% discount rate is applied. Referring to the sensitivity analyses in Appendix 2 and 3, it is also shown how substituting the degrees of risk changes the values of the projects significantly. Considering the DYOD as a medium-risk project will increase the NPV value by 27.5% and by considering

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