New Heritage Doll Company
Capital Budgeting Simulation

We took the approach that the greatest value is created when the choices being made provide the biggest bang for the buck; in other words, the greatest present value return for invested unit of capital, here the US dollar. The equation is the following:

Profitability Index = PV of future cash flows/initial investment.

In every year, and in every case, we chose the highest level of profitability that our budget constraints would allow. If we were faced with a project that had a relatively high PI but lacked the budget to enter into the project, we simply went down the list to the next best PI index level until we came upon a project that we could afford.

The one exception, or choice, that did not involve a pure PI play, was in our decision to be very conservative when choosing the number of stores to open for New Heritage’s retail store expansion. Our common sense approach had us open only one store in the first year to see if it was successful and to follow that up with additional stores in subsequent years to build on its success. That allowed us to open two stores in Year 2 and an additional two stores in Year 3. Once again, just to be safe, we opened only two stores in Year 2. We did this since the original store was a proven success and we wanted to capitalize on its success by adding an additional store opening, but held back on the last two, once again, in case the environment had changed.

Using our approach, our simulation resulted in an APV of 579.34. This, however, is not the end of the story. Considering the retail division’s expectation that retail store expansion would be “no more than medium risk, and it actually would be most efficient to open all the stores simultaneously,” we decided to run the simulation front-loading the expansion with five new stores opening in Year 1.