Introduction to Net Present Value (NPV) - What is Net Present Value (NPV) ? How it impacts financial decisions regarding project management?
At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. 10 Uncommon Values (R): Optimizing the Stock-Selection Process case study is a Harvard Business School (HBR) case study written by Boris Groysberg, Paul M. Healy. The 10 Uncommon Values (R): Optimizing the Stock-Selection Process (referred as “Stocks Uncommon” from here on) case study provides evaluation & decision scenario in field of Organizational Development. It also touches upon business topics such as - Value proposition, Financial management, Financial markets, Human resource management, Leading teams.
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.
In 2003, Steve Hash, research director at Lehman Brothers, prepared to initiate the firm's "Ten Uncommon Values" stock-picking process for the year. An investment committee had to pick the 10 best stocks from about 100 stock ideas presented by the firm's analysts. The performance of the stocks selected for the Ten Uncommon Values had historically been strong--an investment strategy to acquire the recommended stocks and hold them for one year would have outperformed the S&P 500 for 39 of the last 54 years. However, during the latest three years--2000 to 2002--the recommendations had performed poorly, generating an average return of -22.5% vs. -11.7% for the S&P 500. Hash pondered several questions: What was the importance of the Ten Uncommon Values for Lehman Brothers and its clients? How much time and effort should the firm put into the process of selecting stocks for the report? How many members should be on the Investment Policy Committee, and who should be selected? What should the process for selection be? Should analysts whose stocks were selected be compensated for their picks? Finally, should they continue the process? Teaching Purpose: Using both qualitative and quantitative data, to allow students to discuss a range of issues: the optimal process of selecting stocks, the optimal size of the committee, how much time to spend with each analyst, private or public voting on stocks by the committee members, the right decision-making process, and whether incentives play a role in the process.
| Years | Cash Flow | Net Cash Flow | Cumulative Cash Flow |
Discount Rate @ 6 % |
Discounted Cash Flows |
|---|---|---|---|---|---|
| Year 0 | (10005170) | -10005170 | - | - | |
| Year 1 | 3450809 | -6554361 | 3450809 | 0.9434 | 3255480 |
| Year 2 | 3957940 | -2596421 | 7408749 | 0.89 | 3522553 |
| Year 3 | 3948552 | 1352131 | 11357301 | 0.8396 | 3315280 |
| Year 4 | 3225764 | 4577895 | 14583065 | 0.7921 | 2555107 |
| TOTAL | 14583065 | 12648420 |
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 -
Capital Budgeting Approaches
There are four types of capital budgeting techniques that are widely used in the corporate world –
1. Profitability Index
2. Net Present Value
3. Payback Period
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. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Stocks Uncommon 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 Stocks Uncommon have higher preference for cash returns over 4-5 years rather than 10-15 years given the nature of the volatility in the industry.
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
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 Stocks Uncommon 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 Stocks Uncommon 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.
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 | (10005170) | -10005170 | - | - | |
| Year 1 | 3450809 | -6554361 | 3450809 | 0.8696 | 3000703 |
| Year 2 | 3957940 | -2596421 | 7408749 | 0.7561 | 2992771 |
| Year 3 | 3948552 | 1352131 | 11357301 | 0.6575 | 2596237 |
| Year 4 | 3225764 | 4577895 | 14583065 | 0.5718 | 1844341 |
| TOTAL | 10434053 |
(10434053 - 10005170 )
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 | (10005170) | -10005170 | - | - | |
| Year 1 | 3450809 | -6554361 | 3450809 | 0.8333 | 2875674 |
| Year 2 | 3957940 | -2596421 | 7408749 | 0.6944 | 2748569 |
| Year 3 | 3948552 | 1352131 | 11357301 | 0.5787 | 2285042 |
| Year 4 | 3225764 | 4577895 | 14583065 | 0.4823 | 1555635 |
| TOTAL | 9464920 |
At 20% discount rate the NPV is negative (9464920 - 10005170 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Stocks Uncommon to discount cash flow at lower discount rates such as 15%.
Simplest Approach – If the investment project of Stocks Uncommon has a NPV value higher than Zero then finance managers at Stocks Uncommon 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 Stocks Uncommon, then the stock price of the Stocks Uncommon 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.
Project selection is often a far more complex decision than just choosing it based on the NPV number. Finance managers at Stocks Uncommon 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 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.
Understanding of risks involved in 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.
What can impact the cash flow of the project.
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.
Boris Groysberg, Paul M. Healy (2018), "10 Uncommon Values (R): Optimizing the Stock-Selection Process Harvard Business Review Case Study. Published by HBR Publications.
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