1 page report for Financial management Project

________________________________________________________________________________________________________________ Harvard Business School Professor Timothy Luehrman and HBS MBA Heide Abelli prepared this reading to accompany the Finance Simulation: Capital Budgeting (HBP No. 3357). This reading is fictionalized, is not a source of primary data or an illustration of elective or ineffective management and any resemblance to actual persons or entities is coincidental. Copyright © 2010 Harvard Business School Publishing. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business Publishing. Harvard Business Publishing is an affiliate of Harvard Business School.

ONLINE SIMULATION FOREGROUND READING

Finance: Capital Budgeting

Company and Industry Overview 

The New Heritage Doll Company, based in Sacramento, California, was a privately held company 

with  450  employees  and  approximately  $245  million  in  fiscal  2009  revenues.  This  represented 

approximately 8% of the $3.1 billion U.S. doll industry, which was projected to grow by 2% annually 

to $3.4 billion in retail sales by 2013.  In turn, the doll industry represented a 7.4% share of the total 

$42 billion U.S. market for toys and games, which was dominated by global enterprises that enjoyed economies of scale in design, production, and distribution. Revenues were highly seasonal; the largest selling season in the United States coincided with the winter holiday period. 

The doll category included large, soft, and mini dolls, as well as doll clothes and other accessories.   The phenomenon of “age compression”—the tendency of younger children to prefer dolls that had traditionally been designed for older girls—reduced growth in the “baby-doll” sub-segment. Competition among doll producers was vigorous, as a small number of large producers targeted similar demographics and marketed their dolls through the same media. Lasting franchise value for a branded line of dolls was rare; the enormous success of Barbie® dolls was an obvious exception. More recently and on a much smaller scale, New Heritage also had created a durable franchise for its line of heirloom dolls. However, the popularity of most doll lines waned after a few years. 

New Heritage’s Production Division 

New  Heritage  Doll  Co.  had  three  operating  divisions:  a  doll  and  doll‐accessory  production 

division,  a  retailing  division,  and  a  licensing  division.  New  Heritage’s  doll  production  division 

designed and assembled dolls, doll accessories, and children’s accessories into finished product and 

then packaged  them  for shipment. The production division generated $125 million  in  revenue and 

$7.5 million  in  operating  profit  a  year.1    Seventy‐five  percent  of  its  sales were  internal,  to New 

Heritage’s retail division; 25% of its revenues were generated from private‐label goods manufactured 

for other  firms.       The dolls  ranged  from  relatively  inexpensive baby dolls    ($15  to $30  retail price 

range) to fashion dolls modeled after movie stars that were targeted as upscale collectors’ items ($75 

1 The division revenue figures include approximately $95 million of internal sales within divisions which are eliminated when considering consolidated revenue for the company.

R E V I S E D : 1 1 / 0 5 / 1 0

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to $150 range) for the “tween” (ages 8 to 12) demographic.  Doll accessories, which made up 15% of 

the division’s  total  revenue,  included doll  clothing and  “doll gear”  to mimic  real‐life  situations  in 

which the doll “character” might find herself (camping gear, sports gear, etc.). 

Similar  to  other  U.S.  toy  manufacturers,  a  large  portion  of  New  Heritage’s  assembly  and 

packaging was done overseas, in China and Taiwan, using components manufactured by third‐party 

vendors.    However,  manufacturing activities that required precise tolerances or proprietary processes, along with  all  the  creative  functions  (concept  testing,  product  design,  and  product‐

prototype  development)  were  handled  in‐house  at  the  company’s  headquarters  facilities  in 

Sacramento.  

New Heritage’s Retail Division 

The second division of New Heritage Doll Company was the retail division, which generated $190 

million of New Heritage’s revenue and $4.8 million in operating profit.  The retail division managed 

the sale of the dolls and accessories that the production division designed, assembled and packaged. 

The retail division sold its merchandise through three channels: a website (42%), a mail‐order paper 

catalog  (33%), and a network of  retail stores  (25%).    In addition  to  selling merchandise online,  the 

internet home page offered membership clubs  that girls could  join, organized around  favorite doll 

characters, and “doll and girl” fashion newsletters to which girls could subscribe.  The paper catalog 

sales  were  declining,  but  it  was  still  an  important  distribution  channel  for  New  Heritage  Doll 

Company.   

New Heritage Doll Company owned and operated 32 retail stores, each generating average 

annual revenues of $1.5 million.    Stores were located in major metropolitan areas throughout the 

United States and Canada.  The two California stores in Sacramento and San Francisco were the 

flagships.  These stores were followed by openings along the West Coast, in the Southwest, and in the 

Midwest.  The South had been a recent area of expansion, with the company building out its retail 

presence in northern Florida, Georgia, and the Carolinas.  However, the company did not yet have a 

major presence in the Northeast.  Each store, described as an “experiential destination,” was 

architecturally designed so that girls and parents felt that they were visiting and spending a day with 

their favorite doll characters.  One part of each store was designed for the families of toddlers and the 

other for the tween demographic.  Each store offered various activities and entertainment to entice 

the families to stay longer, such as a café, a doll “hair salon,” and rooms to rent for private parties.   

New Heritage’s Licensing Division 

The  third  and  last division  of New Heritage Doll Company was  the media  licensing division, 

which generated annual revenues of $24.5 million and $14.5 million  in operating profit.   It  licensed 

the rights to New Heritage’s branded doll characters and story lines (such as “Jodie, the Sunny Valley 

Girl”)  to  media  publishing  companies  for  use  in  books,  software,  movies,  and  other  products 

featuring  the NH‐branded  doll  characters.     NH  licensed  the  rights  to  use  its  doll  characters  to 

licensees whose  quality  standards  and  demographic  reach matched NH’s  target  consumers well.  

NH’s well‐recognized doll characters had such brand value that NH was able to strike advantageous 

deals with licensees.  The licensing division generated $5 million annually from licensing agreements 

with book publishers; $2.5 million from software and video licenses; $12 million from movie and TV 

licenses; and $5 million from other miscellaneous licensing agreements.  Generally the company tried 

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to negotiate agreements in which it received greater than 50% of the net product revenue.  The media 

licensing strategy reduced the ongoing advertising and marketing spend requirements for individual 

doll brands and generally made the dolls more popular among consumers.  

New Heritage’s Corporate Strategy 

New Heritage’s  CEO  considered  the  company’s  distinctive  skill  to  be  its management  of  the 

creative process  in each of  its divisions.   The company’s overriding strategic goal was  to build and 

grow customer identification with its doll characters in various forms of product and entertainment 

through all stages of a child’s life, from toddlerhood through the teenage years.  To achieve this goal, 

the CEO encouraged expansive and innovative ideas and was very protective of the creative process.   

However, she was also very clear that businesses were expected to meet financial objectives.   

The product division’s long‐term strategy involved building on its core expertise in doll and 

accessory  design  and  development  in  order  to  expand  and  deepen  its  offerings  to  two  key 

demographic customer segments—toddlers/young girls and tweens—each of which offered various 

opportunities  for  growth.   New Heritage’s  retail  division  strategy was  to  expand  geographically 

within  the United  States  across  all  three  channels.    In  the United  States,  the  company planned  to 

continue  to  invest  in  its “retail as entertainment” concept  through store expansion.   However, Asia 

and Europe were also considered strategic markets as the company sought to grow its international 

revenue.  The strategy of the licensing division was to continue to grow revenue derived from New 

Heritage’s core branded assets, but to do so in a reasonable way.  The company recognized that as it 

entered  new  business  opportunities  it  increasingly  faced  the  prospect  of  damaging  its  core  doll 

brands.  

The biggest management and strategic challenge for the company related to coordination of 

activities  among  the  three divisions.   The  company  negotiated  internal  transfer prices  for  activity 

performed by one division for another.  However, initiatives and campaigns in one division needed 

to be carefully coordinated with those in other divisions if the company was to successfully leverage 

its doll character brands across all divisions.  

The Capital Budgeting Process at New Heritage 

The annual investment process at New Heritage began with personnel in each division proposing 

projects for investment that were aligned with the company’s multi‐year strategy plans.  As the company grew, deliberate steps were taken to decentralize some of the project approval process and increase spending authority at the division level. However, large and/or strategic spending proposals were reviewed at the corporate level by a capital budgeting committee consisting of the CEO, CFO, COO, the controller, and the division presidents.  

Each project proposal presented to the committee included the following information:  brief 

description of the project and the strategic rationale; overview base case financials (five‐year 

operating and cash flow forecasts); spending requirements by asset category, personnel requirements,  

key project financial performance measures (NPV, IRR, payback period, profitability index); and 

project risks and milestones.  Proposed projects ran the gamut from relatively minor, tactical projects 

(the replacement of obsolete assembly equipment) to major strategic projects that would significantly 

alter the company’s market position (an acquisition, for example).   Some projects were 

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interdependent across the spectrum of investment opportunities; others were exclusive.  Many 

extended over a multi‐period time horizon and involved a high degree of uncertainty.   

New Heritage’s corporate cost of capital was 7.7%.  However, New Heritage assigned discount rates to projects according to a subjective assessment of each project’s risk. High-, medium-, and low-risk categories for each division were associated with a corresponding discount rate set by the capital budgeting committee in consultation with the corporate treasurer.  Assessments of each project’s risk were made at the division level, but subject to review by the capital committee. Factors considered in the assessment of a project’s risk included, for example, whether it required new consumer acceptance or new technology, high levels of fixed costs and hence high breakeven production volumes, the sensitivity of price or volume to macroeconomic recession, the anticipated degree of price competition, and so forth. For example, in 2010, “medium”-risk projects in the production division received a discount rate of 8.4%. High- and low-risk projects were assessed at 9.0% and 7.7%, respectively.

Projects that created value indefinitely, given continuing investment, were treated as going concerns with a perpetual life. That is, NPV calculations included a terminal value computed as the value of a perpetuity growing at a constant rate. However, to preserve an element of conservatism, the capital committee generally insisted on relatively low perpetual growth rates – lower than New Heritage’s historical growth and lower than near-term growth forecasts for a given division.

The committee examined projects for consistency with New Heritage’s business strategy and sought to balance the needs and priorities of each division against practical financial and organizational constraints. The committee also sought to understand project interdependencies and the potential for a given investment to strengthen the whole company, not solely the division proposing it.

Simulation Game Play 

As  the CEO and  the head of New Heritage’s capital committee, you will decide which projects 

should be funded for implementation.   The board of directors sets an annual limit on dollar funding 

for capital projects.  This limit was generally a function of the firm’s internal resources, its ability to 

raise additional capital, and organizational constraints.   Often, the total amount of funds committed 

to  internal  investments  in  a  given  year  also  depended  on most  recent  operating  results  –  higher 

profitability could  lead to higher capital spending.     (Acquisitions and very  large  investments were 

funded  “off‐budget”  for  example,  by  the  issuance  of  additional  corporate  debt.)  The  company’s 

managers proposed more projects for consideration than could be funded.  As a result, some value‐

creating projects would be rejected due to the limit on available capital.    It was therefore necessary 

for the capital committee to select the best set of investments from the pool of available options in any 

given fiscal year.   

Given the limits on available capital at New Heritage, you will be unable to invest in all proposals, even if 

they are value‐creating and exceed risk‐adjusted hurdle rates.  Your task is to evaluate proposed projects using 

the financial and qualitative information provided and to select projects to be approved for a given year’s 

investment plan using any evaluation criteria you deem appropriate.  You will be required to monitor your 

selected investments, evaluate new investment proposals, and submit annual capital plans over a period of five 

years, from 2010 through 2014. 

Project 2/Finance Simulation_ Capital Budgeting.pdf