Heritage Doll Simulation - Essay Example

? Investment Projects Heritage Doll Simulation Executive Summary The New Heritage Doll Company comprises of three divisions: production, retail and licensing which were responsible for manufacturing and production, sales and licensing of the rights for the doll characters respectively. Every year new projects related to the expansion of the company were undertaken. The rationale for choosing those projects depended on several factors such as the Net present value of the project, the internal rate of return, profitability, riskiness so on and so forth. That is why even projects which had a positive net present value where not considered for the purpose of investment. The annual investment process at New Heritage involved personnel from all the three divisions of the company who presented their proposals for projects which can be considered for the purpose of investment. The proposals included projects which can be considered for the purpose of investment. With the growth of the company, initiatives were taken to decentralize some of the project approval process and hence increase spending authority at the division level. However, some projects which were of significantly higher value and required huge source of funds were reviewed at the corporate level by the capital budgeting committee which consists of the CEO, CFO, COO, the controller and the division presidents. As such, this report involves a thorough analysis of the available investment opportunities that the New Heritage Doll Company can undertake. The analysis spans over five years (2010 - 2014), evaluating projects which can prove to be a value maximising proposition for the company. The projects were analysed on the basis of key performance measures such as Net Present Value, Internal Rate of Return, Profitability Index, Payback period, riskiness, exposure to debt so on and so forth. The projects which were chosen every year for the purpose of investment were submitted to the budgeting committee. This was done through a simulation process. The results from investing in those projects were reflected in the financial performance of the company in the following financial year. This process was repeated for five consecutive years and the company’s performance was analysed. This analysis has been presented in detail in the following sections and comments have been made regarding the projects which were chosen and the rationale for their choice, the budgeting constraint, the choices among all positive NPV projects, the risk factors which were considered and finally the ethical issues faced by the CEO while taking these decisions. Table of Contents 1. Rationale for choice of investing in a particular project 4 2. Budget Constraint 14 3. Choices among all positive NPV projects 14 4. Riskiness of the projects 14 5. Ethical issues faced by the CEO 15 1. Rationale for choice of investing in a particular project Several factors are considered by analysts while choosing a right project for investment. A project proposal to be presented to the committee includes a brief detail about the project and the strategy behind it. Investment decisions are base upon key financial performance measures such as the net present value of the project (NPV), the internal rate of return (IRR), payback period and the profitability index (PI) of the project (Harvard Business Publishing 2010a). Accepting or rejecting a project depends to a large extent on the NPV of the project which is the present value of the benefits less the present value of the costs. However, this is not the only factor which is taken into consideration while evaluating a project. The other factors taken into consideration are IRR (the interest rate that sets the NPV equals to zero), Payback Period (the time required by a company to recover the cost of an investment) and Profitability index (the ratio between the NPV to the resource consumed) (Berk and DeMarzo 2011, 54-167). Having analyzed all the investment opportunities available to New Heritage Doll Company in their production, retail and licensing division, in the year 2010 “Match my doll”, “Retail Store expansion in North East” and “New doll film/DVD” are the projects which were found to be the most viable projects which would generate value for the company owing to their high positive NPVs and IRRs. The profitability of these projects where significantly greater than 1 which is thought to be a critical factor to be taken into account while making investment decisions. Projects having profitability index greater than 1 are good investment opportunities. Although, “New doll film/dvd” had a negative PI but a significantly high IRR and NPV make it look a compelling project. In addition to that the cost of this projects where considerably lower when compared to the return they were generating and hence the cost of capital required for this investment were less thus rendering the projects value generating for the company. Table 1: Key financial performance measures for the year 2010 Table 2: Table 1: Key financial performance measures for the year 2011. Table 3: Table 1: Key financial performance measures for the year 2012. Table 4: Table 1: Key financial performance measures for the year 2013. Table 5: Table 1: Key financial performance measures for the year 2014. Similar factors attributed to the choice of projects in the subsequent years (2011 to 2014) which would result in the value maximization of the company. The projects chosen in the year 2011, 2012, 2013 and 2014 were, Dolls of the World Initiative, Grow the doll line, Toddler doll accessory line, Matching my doll clothing concept, New east coast distribution facility, teen book series, Design your own doll, warehouse facility consolidation, virtual doll community, bookstore cafe and club, Children’s accessories line, doll houses with miniature dolls, expansion to England, Coupon promotions/frequent shopper campaign, toddler music CD series and Young author’s book series. All these projects belonged to the production, retail and licensing division of the company. The NPV, IRR and PI of the projects where comparatively higher than the other investment opportunities while the cost of capital and the payback period required for these projects were significantly lower and thus investment in these projects led to value maximization for the company as is evident from the financial performance data retrieved after the simulation (refer to the figures given below). Table 6: Financial Statements (Company Consolidated) following simulation. Table 7: Financial Statements (Production Consolidated) following simulation. Table 8: Financial Statements (Retail Consolidated) following simulation. Table 9: Financial Statements (Licensing Consolidated) following simulation. Fig 1: Financial performance following simulation for the year 2009. (Source: Harvard Business Publishing, 2010b) Fig 2: Financial performance following simulation for the year 2010. (Source: Harvard Business Publishing, 2010b) Fig 3: Financial performance following simulation for the year 2011. (Source: Harvard Business Publishing, 2010b) Fig 4: Financial performance following simulation for the year 2012. (Source: Harvard Business Publishing, 2010b) Fig 5: Financial performance following simulation for the year 2013. (Source: Harvard Business Publishing 2010b) Fig 6: Financial performance following simulation for the year 2014. 2. Budget Constraint The main budget constraint that proved to be a critical factor affecting the choice of a particular investment was liquidity constraint (Chow, Song and Wong 2010, 12). Sufficient funds were not available for investing in projects having high cost which also generated a high return as was evident from the NPV and IRR. For example, in the year 2011, an acquisition strategy failed due to unavailability of funds, however, that acquisition was projected to be a value maximizing proposition for the company. 3. Choices among all positive NPV projects Apart from the net present value of a project, other factors which were taken into consideration are the Internal rate of return generated by the project, the profitability index, the payback period as well as the EBITDA (Earnings before Interest, tax, depreciation and amortization) generated by the company. Those projects where considered for the purpose of investment which had significantly high internal rate of return as this rate represents the likely earnings per year from that investment. In addition to that profitability index of a particular project was also accounted for as it was the critical factor in determining whether the company is being able to generate high value with the minimum allocation of resources. Thus, the projects having profitability index more than 1 were selected for the purpose of invested as they reflected high value generation with less resource allocation. However, there was just one exception in case of the project “New doll film/DVD.” This project from the licensing division of the new heritage doll company had a negative profitability index (-3.79); however, it was chosen for the purpose of investment as it had very high internal rate of return (238.61%) and net present value (9.25) (Refer to table 5 given above). Furthermore, the payback period for a particular project was also considered for the purpose of evaluation. The payback period is based on a rule that an ideal investment opportunity is the one that pays back the cost if the initial investment quickly (Berk and DeMarzo 2011, 54-167). Thus the project which had minimum payback period compared to the other ones was chosen for the purpose of investment. Making sure that the investment opportunities fits the criteria mentioned above, it was noted that following the investments made from the year 2010 to 2014, the company’s net income, operating profit, revenues and asset value in all the all divisions increased by a good margin from what it was in the previous year (refer to table 6–9 and fig 1–6 provided above). 4. Riskiness of the projects According to Li and Wu (2009), one of the primary strategies managers adopt to diversify corporate risk, allocate pre-determined capital among multiple projects. This is a common practice in the modern day financial management practices. Hence capital budgeting becomes an important tool that managers utilize in order to make decisions involving investment allocation. Therefore it is very important for the manager to account for the downside risk of the company as it measures the uncertainty regarding the payoffs realized in the future from a project invested at present. While analyzing the projects that were available to the New Heritage Doll Company, the risk factors which were taken into account were the requirement of new technology for the purpose of carrying out a new project. This was considered because of the fact in order to incorporate a new technology; a firm would have make to make some investments which would mean that it has to allocate capital according to its capital structure thereby either resorting to debt funds or funds from equity. Both this strategy have equal amount of risk as resorting to debt funds would increase the exposure of the company in terms of debt and thereby would expose the company to interest rate risk. Henceforth, another factor that was taken into consideration was the product generated from the new technology will be well perceived by the consumers or not. Because if the product is not well accepted, this would mean that the investment towards acquiring the asset was not a viable decision and thus this would reduce the value of the company. In addition to that, another risk factor taken into consideration was the projects which might incur high level of fixed as that would mean there would be a high breakeven in the production volume. Moreover, the product price sensitivity to uncertain economic factors such as recession as well as due to the increasing level of competition was also taken into account. The company’s exposure to long term debt was also taken into consideration as it increases the chances of the company facing interest rate risk. Since, the company also had its operations at an international level; it was also susceptible to foreign exchange risk which arises due to the fluctuation in the foreign exchange rates as a result of frequent fluctuations in the demand and supply triggered by external factors (Abor 2005). Taking into considerations all these risk factors, the company assigned higher discount rates depending upon the riskiness of a particular project. Greater the risk, higher the discounting rate (Harvard Business School 2010a). 5. Ethical issues faced by the CEO Ethics is a factor which is of utmost important in the field of corporate governance and henceforth to the performance of a corporation. In addition to a robust governance framework a strict moral code of conduct is also an essential factor contributing towards the performance of an organization (Rossouw 2009). In today’s competitive market, the task of formulating effective governance in order to align a company’s strategy with the financial, social and environmental concerns is highly challenging (Appelbaum, Vigneault, Walker and Shapiro 2009). These gives rise to ethical issues, governance issues as well as principal agent problems. Having worked as a CEO, I myself have faced issues related to business ethics and governance. The toughest challenge was to coordinate the operations taking place within the three divisions of the company. In addition to that due to lack of transparency, there was prevalence of principal – agent problems where, some investment decisions taken by me were being perceived by the stakeholders, to be decisions driven by personal interest which was not the case. Moreover, the lack of robust governance also gave rise to conflict of interest between stakeholders. In order to prevent these kinds of issues from resurfacing, the governance framework should be followed strictly by the board and the management in order to have a strong control over the operations of the organization thereby directing them to achieve the objectives which are in the best interest of the organization and the stakeholders. Reference List Abor, Joshua. 2005. “Managing foreign exchange risk among Ghanaian firms.” The Journal of Risk Finance 6(4): 306-318. Appelbaum, Steven H, Louis Vigneault, Edward Walker, and Barbara T Shapiro. 2009. “Good corporate governance and the strategic integration of meso ethics.” Social responsibility journal 5(4): 525-539. Berk, Jonathan, and Peter, DeMarzo. 2011. Corporate finance. Ney Jersey. Pearson education. Chow, Clement K W, Frank M Song, and Kit Pong Wong. 2010. Investment and the soft budget constraint in China. International Review of Economics and Finance: 1-22. Rossouw, Deon. 2009. “The ethics of corporate governance: Crucial distinctions for global comparisons.” International journal of Law and Management 51(1): 5-9. Harvard Business Publishing. 2010a. Finance: Capital Budgeting. Harvard Business Publishing. Accessed September 30, http://forio.com/simulation/harvard-capital/downloads/capbudget_foreground_reading.pdf Harvard Business Publishing, 2010b. Finance Simulation: Capital Budgeting. Harvard Business Publishing. Accessed September 30, http://forio.com/simulation/harvard-capital/#page=dashboard. Li, Xun, and Zhenyu Wu.2009.“Corporate risk management and investment decisions.” The Journal of Risk Finance 10(2): 155-168. Read More