crucial concepts in financial accounting

IRCO 421B Finance
Spring 2013
IRPS, UC San Diego
Krislert Samphantharak

Assignment 1
Due April 19, 11.59 pm, by email (“Finance B Turnin” on FirstClass)
This assignment serves three main objectives. First, it allows you to review various present value and
discounting concepts and how to compute them using relevant functions in Excel. Second, it helps you
review some crucial concepts in financial accounting that you studied in the last quarter. Finally, it guides
you through the calculation of NPV and other investment criteria we discuss in class. Although the case
is from a privately-owned company in the US, it serves as an illustrative example on how we compute
NPV, IRR, payback period, and profitability index in practice. This procedure could be applied (with
appropriate adjustments) to other investment decision making by other forms of organizations, including
households, publicly-traded companies, not-for-profit organizations, or governments, both in the US and
elsewhere.
Instruction
1. Read “New Heritage Doll Company: Capital Budgeting” case. The case can be purchased from
Harvard Business School Press at
https://cb.hbsp.harvard.edu/cbmp/access/19276442 You need to
register on the site to create a user name if you do not already have one. After you register, you can
get to the coursepack at any time by doing the following:
1. Visit
hbsp.harvard.edu and log in.
2. Click “My Coursepacks
, and then click “Finance B”.
2. Excel file consisting of spreadsheets for Exhibits from the case is also available for download.
3. You should try to think about how to get the answer for each question below before diving to the hints
provided in the study guide.
4. The study guide is mainly numerical financial analysis and do not contain all of the analysis you need
in order to solve the case. In other words, going through the guideline is not sufficient for addressing
all the issues raised in the questions.
5. Remember that the study guide provides just one of the many ways to analyze the case. You are
not
required to follow it. Alternative sensible financial analysis is perfectly acceptable.
6. Again, do not forget to address other issues listed in the questions that are not analyzed in the study
guide.
7. Turn in your assignment by emailing the following two files to “Finance B Turnin” on FirstClass:
a. A memo that addresses the questions below. The memo should be structure as if it were an
executive summary submitted to your boss or your client. For this assignment, the memo cannot
be longer than one page. Refer to the numbers your compute in Excel spreadsheets when
necessary, but no detailed calculation is needed in the memo.
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b. An Excel file that contains all calculations that give you the final numbers. The file must be selfcontained and understandable to general readers outside your group.
How to Solve Case Study?
I assume that you are somewhat familiar with case solving. Most of the suggestions for general case
study apply to this course as well. However, cases in finance have some distinct features. My additional
suggestions are as follows:
1.
Details matter here. A lot. Exhibits are extremely important and the heart of your financial analysis lies
somewhere in those exhibits. Make sure to spend time studying them carefully.
2.
Use ‘macro-micro-macro’ approach. Start the case by reading it carefully, preferably twice. Grab the
macro context of the case—the settings, the development, and the current issues. Then, try to dive
into the pool of numbers. Perform relevant financial analysis in detail. Finally, put the results from your
analysis back into the macro picture of the case. Provide strategy and policy suggestions.
3.
Stay within the case. Use all information you can get from the case, both in the text and in the
exhibits. I sometimes provide additional information for you. However, do not use information from
other sources, especially in retrospect. If you feel that the information provided by the case is not
sufficient, feel free to make additional assumptions. Note that the assumptions you make should be
justifiable and should be based on the information in the case. Ambiguous cases give you an
opportunity to practice making necessary assumptions and making final decisions under the
imperfect information environment.
Questions
1. Compare the business cases for each of the two projections under considerations by Emily Harris.
Qualitatively, which one do you regard as more compelling?
2. Use the operating projections to compute a net present value (NPV) for each project. Which project
creates more value?
3. Compute the internal rate of return (IRR) and payback period for each project. How should these
metrics affect Harris’s deliberations? How do they compare to NPV as tools for evaluating projects?
When and how would you use each?
4. What additional information does Harris need to complete her analyses and compare the two
projects? What specific questions should she ask each of the project sponsors?
5. If Harris is forced to recommend only one project over the other, which should she recommend?
Why?
Study Guide for New Heritage Doll
The company has two project proposals: Match My Doll Clothing expansion (MMDC) and Design Your
Own Doll
(DYOD) initiative. The case analyzes various investment criteria for New Heritage Doll. We will
start with NPV, and then move on to other criteria.
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A. NPV for MMDC
We start by focusing on MMDC. In order to compute NPV for MMDC, we need two ingredients: discount
rate and cash flow forecasts
1. Discount rate: From the case, what is the discount rate you should use for MMDC? Why?
2. Expected cash flows:
a. In class, we know that free cash flow (FCF) = EBITDA*(1 – t) + Depreciation*t – Change in NWC –
CAPEX. Show that we can rewrite this expression and compute FCF from FCF = EBIT*(1-t) +
Depreciation – Change in Net Working Capital – Capital Expenditure.
b. Compute EBIT for each year from 2010 to 2020. Compute after-tax EBIT, i.e. EBIT*(1-t), for each
of those years. (Hint: Get the tax rate, t, from the case.)
c. Working capital in this case consists of four components: (1) cash, (2) account receivables, (3)
inventories, and (4) account payables. Compute each of these four items of working capital. (Hint:
You may need to review your Accounting lecture on how each of the working capital is related to
turnover ratio etc.)
Once you get the amount of cash, account receivables, inventories, and account payables for
each year, compute net working capital (NWC), which is defined as cash + account receivables +
inventories – account payables. (Also, try to think what NWC means in our context.) Finally,
compute changes in NWC from year to year.
d. Finally, compute free cash flow (FCF) for each year from 2010 to 2020.
e. In principle, we need to forecast future cash flows through the end of the project. What is left at
the end of the project could be sold and recorded as a cash inflow at the end of the project. This
inflow is called a
salvage value. In this case, however, the project is assumed to last forever, i.e.
there is no end date. This is very common when we value any infinitely-lived projects. In order to
deal with this situation, we make an additional assumption that after some point in the future (say,
2020 for MMDC in this case), the project will become mature and it will grow at a constant rate
forever. With this assumption, we can calculate the value of the MMDC project
in 2020. This is
called the terminal value. In other words, the terminal value represents the value, at the end of the
explicit forecast period, of all cash flows occurring after that point.
Assume that from 2020 onward, FCF for MMDC will grow at 3% per year. (Justify my
assumption of this growth rate. Do you agree or disagree with this assumption? Why?) The
terminal value, i.e. the present value of future (growing) FCF from 2020 onward can be
computed as a
growing perpetuity. (Why?) Compute this terminal value of MMDC in 2020.
3. Net Present Value: With the discount rate and expected FCF we get, compute NPV of MMDC. (Also,
review Excel function NPV.)
B. NPV for DYOD
Repeat steps 1-3 above and compute NPV for DYOD.
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C. Other Investment Criteria
1. IRR: Internal Rate of Return is the discount rate for which NPV = 0. Compute and compare IRRs for
MMDC and DYOD. (You should think also what the intuition behind IRR is. Also, review Excel function
IRR)
2. Payback Period: Payback is the period at which cumulative cash flow becomes positive. Compute
and compare paybacks for MMDC and DYOD.
3. Profitability Index: Compute and compare profitability indices for MMDC and DYOD. It is defined as
NVP/Initial Outlay.
D. Putting Everything Together
Consider NPV, IRR, payback, and profitability index you get from above, what investment project(s)
should Emily Harris recommend if New Heritage Doll does not have limited resource. What if the
company has resource to invest in only one project, what should be her recommendation?
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