Great Eastern Toys
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Case Study
“Great Eastern Toys”
Designer Dolls’ Project — How to evaluate?
Within the scope of Finance course, we are asked to apply our acquired knowledge in the analysis of the case study “Great Eastern Toys”, in order to build a solid decision concerning whether a new project should be taken or not by this firm.
As a brief explanation, Great Eastern Toys firm is planning to extend its existing product line of plastic dolls by entering the market for designer dolls. Several studies were undertaken in order to estimate future cash flows of this project.
After this step, the firm has to evaluate the project based on the information given by those studies. If so, which path should the firm follow as a means to reach a conclusion of either accepting/ rejecting the project?
Our job, is precisely to tell how relevant is this information, and why should we consider it in our calculations that lead to the project’s approval or rejection.
First of all, we need to mention which theoretical approach we considered to calculate the viability of the project. Without any surprise, we chose the NPV method.
Conceptually, the Net Present Value is the present value of future cash flows minus the present value of the cost of the investment, which determines the exact cost or benefit of a decision. Consequently, the NPV rule states that if NPV is negative we should reject the project, or conversely, if is positive, we should accept it.
But, why did we choose this method rather then Payback or Internal Rate of Return, for example? Simply, because NPV is the best method in leading to good investment decisions, as it uses all relevant cash flows of the project and discount them to their present value (time-value of money is absolutely important to the project evaluation). In addition, the NPV interpretation tells us by which amount the value of the firm will change if the project is taken.
Nevertheless, it does not mean that other mentioned methods above cannot be used. IRR approach is also possible, giving us the break-even rate of the project, i.e. the rate that makes the NPV of the project to be zero. Payback method is not so commonly used, but, under specific assumptions, it can be calculated aiming to find other special features of the project.
Therefore, after this methodology introduction, we may proceed to the NPV analysis of the project.
NPV Analysis
The most important thing to do before calculating the NPV is to identify the relevant cash flows of the designer doll project, i.e. the ones that are incremental to the project. We should only consider this type of cash flows, and dismiss the other ones, since we are only interested in changes in the firm’s cash flows that happen as a direct consequence of accepting the project.
The first cash flow we should ignore is the consultant’s market study cost (HK$500.000), because it has already occurred despite deciding for or against the project. Hence, it is not an incremental cash flow, and it belongs to the category of sunk costs.
What about erosion costs cash flows?
Are there any transfers from other elements of the existing production line of plastic dolls into the cash flows of the new project?
First, we have to think about the new product — a designer doll.
Is this kind of doll likely to compete with other dolls from Great Eastern Toys, negatively affecting their cash flows? It is discussable. This issue concerning the existence of “erosion” costs might not be reasonable in this case, as the market for high-margin, high-quality, designer dolls is a niche market, such that its consumers have a higher purchasing power and very specific needs, which are not being generally fulfilled by the existing standard dolls produced by this firm. Therefore, it is not clear that the introduction of a new designer doll would decrease other dolls’ sales and consequently their cash flows. Moreover, this new project should have an inherent strategy, imperatively coherent with the preceding strategies, targets a sharp segment and has a clear positioning in the market. Unless market trends, market environment or consumer buying behaviour evolve in an unexpected way, we are assuming that firm cash flows from other projects will keep fairly constant in the next 5-years period.
Under this assumption, erosion costs, which are defined by reductions on the cash flows from other existing projects as a side effect from the new project, are not being taken into account.
However, we might argue, as well, that the scenario predicted by the sales manager, Robert Ho, is more likely to occur, if we strongly suspect changes in consumer’s perceptions and buying behaviour for dolls purchasing will happen shortly. According with these expectations, we must include erosion costs in the incremental cash flows evaluation.
Due to this difficulty in either considering erosion costs as an incremental cash flow, or just dismiss it, we will analyse both scenarios, and reach a final conclusion according with the assumptions assumed in each of them.
Note: This point will be addressed in the conclusion section.
As we have mentioned above, the relevant cash flows to calculate the NPV of the project are the incremental cash flows, which mainly include the operating cash flows and the investment cash flows.
Operating Cash Flows
Operating cash flows are obtained through income calculation and taxes on income.
Production
Price
Sales Revenue
Cost per unit
Operating Costs
36.000
10.800.000
141,3333333
5.088.000
36.000
10.800.000
141,3333333
5.088.000
36.000
10.800.000
141,3333333
5.088.000
36.000
10.800.000
141,3333333
5.088.000
36.000
10.800.000
141,3333333
5.088.000
Table 1
As we may see in Table 1, using the data on production