Lantian Stock: The 600-Word Spell on a Transformed State-Owned Enterprise in China Net Present Value (NPV) / MBA Resources

Introduction to Net Present Value (NPV) - What is Net Present Value (NPV) ? How it impacts financial decisions regarding project management?

NPV solution for Lantian Stock: The 600-Word Spell on a Transformed State-Owned Enterprise in China case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Lantian Stock: The 600-Word Spell on a Transformed State-Owned Enterprise in China case study is a Harvard Business School (HBR) case study written by Amy Lau, Raymond Wong, Claudia H. L. Woo. The Lantian Stock: The 600-Word Spell on a Transformed State-Owned Enterprise in China (referred as “Lantian Stock” from here on) case study provides evaluation & decision scenario in field of Leadership & Managing People. It also touches upon business topics such as - Value proposition, Compensation, Corporate governance, Ethics, Financial management, Government.

The net present value (NPV) of an investment proposal is the present value of the proposal’s net cash flows less the proposal’s initial cash outflow. If a project’s NPV is greater than or equal to zero, the project should be accepted.

NPV = Present Value of Future Cash Flows LESS Project’s Initial Investment

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Case Description of Lantian Stock: The 600-Word Spell on a Transformed State-Owned Enterprise in China Case Study

Lantian Stock was China's first state-owned agricultural enterprise to have gone through the corporatization reform in mid 90's. Since its listing in 1996, Lantian Stock had recorded a dazzling performance in its financial statements. However, in October 2001, its resplendent image was smashed by an academic researcher, Liu Shuwei with her powerful 600-word article that pointed out the liquidity crisis of Lantian Stock. Consequently, all banks in China refused to extend loans to the company. Meanwhile, Liu faced defamation prosecution brought up by the company who initially denied the allegation. The defamation charge was dropped eventually as the Chinese regulators began to unveil the hidden truth that Lantian Stock had indeed involved in misreporting and perpetrating accounting fraud. Chinese media also dug up the controversial background, mythical tales and the previous fraud record of Lantian Stock. Since Liu could uncover the misstatement based on some basic financial ratio analysis, she remained skeptical about why such wrongdoings had not been discovered by related parties earlier. Alternately, the auditing or CPA firm of Lantian Stock commented that the fraud was undetectable as it had gone far beyond what CPAs could discover from its required procedure, and blamed it on the Chinese environment that was conducive to accounting fraud. Was the circumstance of Lantian Stock scandal as what the CPA had claimed?

Case Authors : Amy Lau, Raymond Wong, Claudia H. L. Woo

Topic : Leadership & Managing People

Related Areas : Compensation, Corporate governance, Ethics, Financial management, Government

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Calculating Net Present Value (NPV) at 6% for Lantian Stock: The 600-Word Spell on a Transformed State-Owned Enterprise in China Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10001391)	-10001391	-	-
Year 1	3461411	-6539980	3461411	0.9434	3265482
Year 2	3982211	-2557769	7443622	0.89	3544154
Year 3	3965176	1407407	11408798	0.8396	3329238
Year 4	3248523	4655930	14657321	0.7921	2573134
TOTAL			14657321		12712008

The Net Present Value at 6% discount rate is 2710617

In isolation the NPV number doesn't mean much but put in right context then it is one of the best method to evaluate project returns. In this article we will cover -

Different methods of capital budgeting

What is NPV & Formula of NPV,
How it is calculated,
How to use NPV number for project evaluation, and
Scenario Planning given risks and management priorities.

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Capital Budgeting Approaches

Methods of Capital Budgeting

There are four types of capital budgeting techniques that are widely used in the corporate world –

1. Payback Period
2. Internal Rate of Return
3. Net Present Value
4. Profitability Index

Apart from the Payback period method which is an additive method, rest of the methods are based on Discounted Cash Flow technique. Even though cash flow can be calculated based on the nature of the project, for the simplicity of the article we are assuming that all the expected cash flows are realized at the end of the year.

Discounted Cash Flow approaches provide a more objective basis for evaluating and selecting investment projects. They take into consideration both –

1. Timing of the expected cash flows – stockholders of Lantian Stock have higher preference for cash returns over 4-5 years rather than 10-15 years given the nature of the volatility in the industry.
2. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Lantian Stock shareholders have preference for diversified projects investment rather than prospective high income from a single capital intensive project.

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Formula and Steps to Calculate Net Present Value (NPV) of Lantian Stock: The 600-Word Spell on a Transformed State-Owned Enterprise in China

NPV = Net Cash In Flowt1 / (1+r)t1 + Net Cash In Flowt2 / (1+r)t2 + … Net Cash In Flowtn / (1+r)tn
Less Net Cash Out Flowt0 / (1+r)t0

Where t = time period, in this case year 1, year 2 and so on.
r = discount rate or return that could be earned using other safe proposition such as fixed deposit or treasury bond rate. Net Cash In Flow – What the firm will get each year.
Net Cash Out Flow – What the firm needs to invest initially in the project.

Step 1 – Understand the nature of the project and calculate cash flow for each year.
Step 2 – Discount those cash flow based on the discount rate.
Step 3 – Add all the discounted cash flow.
Step 4 – Selection of the project

Why Leadership & Managing People Managers need to know Financial Tools such as Net Present Value (NPV)?

In our daily workplace we often come across people and colleagues who are just focused on their core competency and targets they have to deliver. For example marketing managers at Lantian Stock often design programs whose objective is to drive brand awareness and customer reach. But how that 30 point increase in brand awareness or 10 point increase in customer touch points will result into shareholders’ value is not specified.

To overcome such scenarios managers at Lantian Stock needs to not only know the financial aspect of project management but also needs to have tools to integrate them into part of the project development and monitoring plan.

Calculating Net Present Value (NPV) at 15%

After working through various assumptions we reached a conclusion that risk is far higher than 6%. In a reasonably stable industry with weak competition - 15% discount rate can be a good benchmark.

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 15 %	Discounted Cash Flows
Year 0	(10001391)	-10001391	-	-
Year 1	3461411	-6539980	3461411	0.8696	3009923
Year 2	3982211	-2557769	7443622	0.7561	3011124
Year 3	3965176	1407407	11408798	0.6575	2607168
Year 4	3248523	4655930	14657321	0.5718	1857354
TOTAL					10485567

The Net NPV after 4 years is 484176

(10485567 - 10001391 )

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Calculating Net Present Value (NPV) at 20%

If the risk component is high in the industry then we should go for a higher hurdle rate / discount rate of 20%.

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 20 %	Discounted Cash Flows
Year 0	(10001391)	-10001391	-	-
Year 1	3461411	-6539980	3461411	0.8333	2884509
Year 2	3982211	-2557769	7443622	0.6944	2765424
Year 3	3965176	1407407	11408798	0.5787	2294662
Year 4	3248523	4655930	14657321	0.4823	1566610
TOTAL					9511206

The Net NPV after 4 years is -490185

At 20% discount rate the NPV is negative (9511206 - 10001391 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Lantian Stock to discount cash flow at lower discount rates such as 15%.

Acceptance Criteria of a Project based on NPV

Simplest Approach – If the investment project of Lantian Stock has a NPV value higher than Zero then finance managers at Lantian Stock can ACCEPT the project, otherwise they can reject the project. This means that project will deliver higher returns over the period of time than any alternate investment strategy.

In theory if the required rate of return or discount rate is chosen correctly by finance managers at Lantian Stock, then the stock price of the Lantian Stock should change by same amount of the NPV. In real world we know that share price also reflects various other factors that can be related to both macro and micro environment.

In the same vein – accepting the project with zero NPV should result in stagnant share price. Finance managers use discount rates as a measure of risk components in the project execution process.

Sensitivity Analysis

Project selection is often a far more complex decision than just choosing it based on the NPV number. Finance managers at Lantian Stock should conduct a sensitivity analysis to better understand not only the inherent risk of the projects but also how those risks can be either factored in or mitigated during the project execution. Sensitivity analysis helps in –

What are the uncertainties surrounding the project Initial Cash Outlay (ICO’s). ICO’s often have several different components such as land, machinery, building, and other equipment.

Understanding of risks involved in the project.

What will be a multi year spillover effect of various taxation regulations.

What can impact the cash flow of the project.

What are the key aspects of the projects that need to be monitored, refined, and retuned for continuous delivery of projected cash flows.

Some of the assumptions while using the Discounted Cash Flow Methods –

Projects are assumed to be Mutually Exclusive – This is seldom the came in modern day giant organizations where projects are often inter-related and rejecting a project solely based on NPV can result in sunk cost from a related project.

Independent projects have independent cash flows – As explained in the marketing project – though the project may look independent but in reality it is not as the brand awareness project can be closely associated with the spending on sales promotions and product specific advertising.

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Negotiation Strategy of Lantian Stock: The 600-Word Spell on a Transformed State-Owned Enterprise in China

References & Further Readings

Amy Lau, Raymond Wong, Claudia H. L. Woo (2018), "Lantian Stock: The 600-Word Spell on a Transformed State-Owned Enterprise in China Harvard Business Review Case Study. Published by HBR Publications.