IBM Culture in Its Architecture 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 IBM Culture in Its Architecture case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. IBM Culture in Its Architecture case study is a Harvard Business School (HBR) case study written by A. Eugene Kohn, Kerry Herman. The IBM Culture in Its Architecture (referred as “Gerstner Ibm” from here on) case study provides evaluation & decision scenario in field of Organizational Development. It also touches upon business topics such as - Value proposition, Design.

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 IBM Culture in Its Architecture Case Study

In 1992, Lou Gerstner was the CEO of IBM during a period where the firm was losing money and a turnaround was desperately needed. In a bold decision, Gerstner chose to build a new headquarters in Armonk, NY that had strict limits on expandability. His idea was to use the building--with its design and architecture--to change the culture of IBM. Justification to shareholders for a large capital expenditure when the firm was losing $5 billion by year and laying off nearly 25,000 employees was an extreme challenge for Gerstner. However, he was adamant in his vision, and wanted to create a culture with fluid, unobstructed communication between divisions. Gerstner also wanted to eliminate bloated overhangs within the organization on cost, personnel, and physical structure levels. The challenge to the architects was to articulate Gerstner's ideas into form.

Case Authors : A. Eugene Kohn, Kerry Herman

Topic : Organizational Development

Related Areas : Design

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Calculating Net Present Value (NPV) at 6% for IBM Culture in Its Architecture Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10028880)	-10028880	-	-
Year 1	3462837	-6566043	3462837	0.9434	3266827
Year 2	3975719	-2590324	7438556	0.89	3538376
Year 3	3966685	1376361	11405241	0.8396	3330505
Year 4	3245717	4622078	14650958	0.7921	2570912
TOTAL			14650958		12706620

The Net Present Value at 6% discount rate is 2677740

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

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

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Formula and Steps to Calculate Net Present Value (NPV) of IBM Culture in Its Architecture

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 Organizational Development 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 Gerstner Ibm 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 Gerstner Ibm 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	(10028880)	-10028880	-	-
Year 1	3462837	-6566043	3462837	0.8696	3011163
Year 2	3975719	-2590324	7438556	0.7561	3006215
Year 3	3966685	1376361	11405241	0.6575	2608160
Year 4	3245717	4622078	14650958	0.5718	1855749
TOTAL					10481286

The Net NPV after 4 years is 452406

(10481286 - 10028880 )

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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	(10028880)	-10028880	-	-
Year 1	3462837	-6566043	3462837	0.8333	2885698
Year 2	3975719	-2590324	7438556	0.6944	2760916
Year 3	3966685	1376361	11405241	0.5787	2295535
Year 4	3245717	4622078	14650958	0.4823	1565257
TOTAL					9507406

The Net NPV after 4 years is -521474

At 20% discount rate the NPV is negative (9507406 - 10028880 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Gerstner Ibm 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 Gerstner Ibm has a NPV value higher than Zero then finance managers at Gerstner Ibm 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 Gerstner Ibm, then the stock price of the Gerstner Ibm 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 Gerstner Ibm 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 will be a multi year spillover effect of various taxation regulations.

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 can impact the cash flow of the project.

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 IBM Culture in Its Architecture

References & Further Readings

A. Eugene Kohn, Kerry Herman (2018), "IBM Culture in Its Architecture Harvard Business Review Case Study. Published by HBR Publications.