"1Name:Designation: Chief Executive OfficerNew Heritage Doll CompanyCapital Budgeting ReportNew Heritage Doll Company 2SummaryBudget is a quantitative blue-print for action. It is an operating plan comprising a detailedestimate of future transactions. Budget is a statement of planning for estimated income andcorresponding expenses of a concern for the future course of action. Capital budgeting means theprobable investment of capital and their long-term planning of financial provisions. It is theprocess of identifying, analysing, and selecting investment projects whose returns are expected toextend beyond one year. Capital expenditure is an expenditure incurred for acquiring orimproving the fixed assets, and capital budgeting involves planning and control of capitalexpenditure. Thus capital budgeting decision may be defined as the firm’s decision to invest incurrent funds most efficiently in long-term in anticipation of an expected flow of future benefitsover a series of years. The future benefits may be derived in different ways; by reducing costs,by increasing revenues, by simplification of the production process, or by improving productquality. The report consists of appraisal of investment proposals and selecting one. There are twomutually exclusive investment opportunities in front of New Heritage Doll Company. In order toappraise the two proposals, namely Match My Doll Clothing and Design Your Own Doll, thecapital budgeting techniques applied for the evaluation process are; Free Cash Flow to the Firm(FCFF), Net Present Value (NPV), Pay Back Period (PBP), Terminal Value (TV) andProfitability Index (PI). The two projects have different riskiness. While Match My DollClothing is moderately risky, Design Your Own Doll is highly risky, as per assessment of risksinvolved with the projects. Factors considered for assessing the risks involved with the projectsare; whether new consumer acceptance or new technology are required, high levels of fixed costand resultant high beak-even point, the sensitivity of price and volume to macroeconomicrecessions, and the anticipated degree of price competition. The accompanying excel sheetsconsist of the detailed arithmetical calculations as per different formulas of capital budgetingtechniques as applied in the appraisal process. The report contains introduction, different capitalbudgeting techniques as applied to the present financial data, conclusion based on the appraisalof the investment proposals, appendix, and references.IntroductionFounded in 1985 by Ingrid Beckwith, New Heritage Doll Company has been developing lines ofdolls for different age brackets with unique story lines and wholesome themes. In 2009 thecompany generated approximately $245 million of revenue and earned operating profit of $27million with the assistance of 450 employees. The company has three divisions, namelyproduction, retailing, and licensing. In 2009, the retailing division generated $190 million worthrevenue and earned operating profit of $4.8 million. The relatively new licensing division is themost profitable division. In 2009 the division generated revenue of $24.5 million and earnedoperating profit of $14.5 million. The production division is the most asset-intensive division of 3the company and 75% of the production goes to the retailing division and remaining 25% consistof private label goods manufactured for other firms. The company outsources much of itsproduction to trusted contract manufacturers in Asia. Production activities that require precisetolerance or proprietary process are carried on in-house. The production department has proposed two mutually exclusive investment proposals;expanding the successful Match my Doll Clothing and starting a new initiative Design Your OwnDoll. On the basis of data provided for the two investment proposals including riskiness of thetwo projects, the most broadly used capital budgeting techniques are applied to assess viabilitiesof the two projects. The rest of the report deals with the different techniques used, the resultsobtained by using the methods and a conclusion that includes recommendation.Free Cash FlowsFinancial statements including cash flow statement provide details of a company’s financialposition. In order to understand the firm’s ability to make capital expenditure and coverexpenses, the cash flow must be reviewed. Cash flow refers to the cash and cash equivalentsentering and leaving the company during a given period. The cash is obtained by the firm fromregular operations, from investing and from financing activities. Cash flow statement records theincoming and outgoing of cash during a period. A positive cash flow enables the company to re- invest the cash and a negative cash flow constrains the company from doing so. The cash flow statement (see the appendix) prepared for New Heritage Doll Company as regardsthe two mutually exclusive investment proposals reveal that both the investments result innegative cash flows. Financially sound and operationally efficient company would have positiveEBITDA, positive operational cash flow, and minimal new financing cash flow. Negative cashflows do not necessarily mean that the financial performance of the company is poor, but it isindeed an indication that the company should take steps to manage its cash in better way or toavail cash from other sources of capital. The negative FCFF for both the projects show that thereare errors in anticipating the future cash inflows and out flows and the overall operatingefficiency of the firm needs to be improved to a great extent (Chron 2016). Terminal Value 4Terminal value refers to the value of a business or an investment project beyond the projectionperiod in discounted cash flow (DCF) analysis. It is the present value of all future cash flowsbeyond the projection period (Macabacus 2016). Terminal values can be calculated by twomethods; Terminal Multiple Method and Perpetuity Growth Method. Given the data in the instantcase Perpetuity Growth Method is applied.Terminal value = {FCF in the last year x (1 + g)}/ WACC – gg = perpetuity growth rateWACC = Weighted Average Cost Of CapitalThe terminal values of both the projects are found to be negative. Please refer to the excel sheetfor detailed calculations. Riskiness and Discount RatesRiskiness of the projects are found out by taking into consideration certain facts, like acceptanceof the products, high break-even points, requirement of new technology, etc. Accordingly Matchmy Doll Clothing is taken to me moderately risky and 8.4% discount rate is applied, and DesignYour Own Doll is found to be highly risky and hence higher discount rate of 9.0% is applied.Non-cash ExpenditureDepreciation is not any actual cash outlay, rather it is book entry for making provision of fundsfor replacement of assets after expiry of the asset’s useful life. Since depreciation does not entailany actual cash payments, it is not cash outflow, and hence added back to PAT in appraisalprocess of capital investments.Net Present ValueNPV is widely accepted method of assessing investment proposal. It is the difference betweenpresent values of cash inflows and present values of cash out flows. The rule is if the NPV ispositive accept the project and if negative reject it. For a stand-alone project NPV with zerovalue may be accepted. In the instant case NPV of both the projects are negative, hence noproject should be selected. Please refer to the excel sheet for detailed calculations.PBP and PI 5Payback period (PBP) is the time required to recover the initial investment expenditure. Sinceboth the projects stand zero chance of recovery of costs, there is no PBP. Profitability index (PI)is the ratio between PV of cash inflows and PV of cash outflows. In both the projects PI is lessthan one signifying negative NPVs. Please refer to the excel sheet. RecommendationsThe appraisal of the two projects by applying the tools shows that none of the projects is worthpursuing. Budget ConstraintsThe resources, key personnel and price competition are some of the budget constraints faced bythe company.ConclusionFrom the foregoing analysis the conclusion that can be grounded is that the company should notpursue any of the investment proposals as none would add to shareholders’ value. May be thefinancial information and data as supplied need to be scrutinized or else new investmentproposals are to be considered.6ReferencesChron (2016). Does a Negative Cash Flow Mean a Company's Financial Performance Was Bad? Retrieved September 22, 2016 from http://smallbusiness.chron.com/negative-cash-flow- mean-companys-financial-performance-bad-60010.html Macabacus (2016). Terminal Value. Retrieved September 22, 12016 fromhttp://macabacus.com/valuation/dcf/terminal-value"