Stonestreet Farms: Making a Business in the "Sport of Kings" 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 Stonestreet Farms: Making a Business in the "Sport of Kings" case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Stonestreet Farms: Making a Business in the "Sport of Kings" case study is a Harvard Business School (HBR) case study written by George Foster, David W. Hoyt. The Stonestreet Farms: Making a Business in the "Sport of Kings" (referred as “Racing Horse” 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, .

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 Stonestreet Farms: Making a Business in the "Sport of Kings" Case Study

By the early 21st century, the economics of thoroughbred horse racing in the United States was backwards - owners invested about four times as much money into the sport than the total amount of purse money available. Owners raced their horses as early as possible, and for as short a time as possible to prove that they were valuable for breeding-then sold them to breeding operations. The industry relied heavily on new entrants who had money from outside horse racing to buy and race their foals. Stonestreet Farms was founded by Jess Jackson, a billionaire wine entrepreneur, who invested more than $200 million in the sport. Unlike most in the horse racing business, Stonestreet was involved in both training and racing horses and in breeding. Two of its horses, Curlin and Rachael Alexandra, won the coveted North American Horse of the year for three consecutive years, from 2007-2009. Both later became part of Stonestreet's breeding operation. This case discusses the challenges facing owners and breeders in the North American thoroughbred racing industry. It can be used as a companion case to SPM-49: Del Mar Racetrack: Reinventing the Horse Racing Fan Experience, which focuses on the industry from the perspective of race tracks.

Case Authors : George Foster, David W. Hoyt

Topic : Leadership & Managing People

Related Areas :

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Calculating Net Present Value (NPV) at 6% for Stonestreet Farms: Making a Business in the "Sport of Kings" Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10018353)	-10018353	-	-
Year 1	3453249	-6565104	3453249	0.9434	3257782
Year 2	3978230	-2586874	7431479	0.89	3540611
Year 3	3946597	1359723	11378076	0.8396	3313639
Year 4	3249055	4608778	14627131	0.7921	2573556
TOTAL			14627131		12685587

The Net Present Value at 6% discount rate is 2667234

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. Net Present Value
3. Profitability Index
4. Internal Rate of Return

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 Racing Horse 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. Racing Horse 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 Stonestreet Farms: Making a Business in the "Sport of Kings"

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 Racing Horse 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 Racing Horse 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	(10018353)	-10018353	-	-
Year 1	3453249	-6565104	3453249	0.8696	3002825
Year 2	3978230	-2586874	7431479	0.7561	3008113
Year 3	3946597	1359723	11378076	0.6575	2594952
Year 4	3249055	4608778	14627131	0.5718	1857658
TOTAL					10463548

The Net NPV after 4 years is 445195

(10463548 - 10018353 )

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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	(10018353)	-10018353	-	-
Year 1	3453249	-6565104	3453249	0.8333	2877708
Year 2	3978230	-2586874	7431479	0.6944	2762660
Year 3	3946597	1359723	11378076	0.5787	2283910
Year 4	3249055	4608778	14627131	0.4823	1566867
TOTAL					9491144

The Net NPV after 4 years is -527209

At 20% discount rate the NPV is negative (9491144 - 10018353 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Racing Horse 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 Racing Horse has a NPV value higher than Zero then finance managers at Racing Horse 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 Racing Horse, then the stock price of the Racing Horse 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 Racing Horse 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 can impact the cash flow of the project.

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

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

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 Stonestreet Farms: Making a Business in the "Sport of Kings"

References & Further Readings

George Foster, David W. Hoyt (2018), "Stonestreet Farms: Making a Business in the "Sport of Kings" Harvard Business Review Case Study. Published by HBR Publications.