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Internal Revenue Service: Automated Collection System 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 Internal Revenue Service: Automated Collection System case study


At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Internal Revenue Service: Automated Collection System case study is a Harvard Business School (HBR) case study written by Nitin Nohria, John Chalykoff. The Internal Revenue Service: Automated Collection System (referred as “Acs Collection” from here on) case study provides evaluation & decision scenario in field of Organizational Development. It also touches upon business topics such as - Value proposition, Corporate governance, Human resource management, IT, Organizational structure, Policy.

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




Case Description of Internal Revenue Service: Automated Collection System Case Study


Describes how the IRS's collection operations changed from a largely manual system (COF) to an automated system (ACS). A central aspect of ACS was the electronic scheduling and maintaining of work. While with ACS the IRS accomplished significant improvements in the task efficiency of its collection operations, the system also led to greater turnover and lower employee morale. This raises questions of how the system could be redesigned. The primary teaching objective of the case is to show how information technology, control systems, and organization design are intertwined and how any change effort must address all three aspects simultaneously.


Case Authors : Nitin Nohria, John Chalykoff

Topic : Organizational Development

Related Areas : Corporate governance, Human resource management, IT, Organizational structure, Policy




Calculating Net Present Value (NPV) at 6% for Internal Revenue Service: Automated Collection System Case Study


Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Discounted
Cash Flows
Year 0 (10009048) -10009048 - -
Year 1 3470016 -6539032 3470016 0.9434 3273600
Year 2 3968552 -2570480 7438568 0.89 3531997
Year 3 3950760 1380280 11389328 0.8396 3317134
Year 4 3243303 4623583 14632631 0.7921 2569000
TOTAL 14632631 12691731


The Net Present Value at 6% discount rate is 2682683

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.




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. Internal Rate of Return
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 Acs Collection 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. Acs Collection shareholders have preference for diversified projects investment rather than prospective high income from a single capital intensive project.




Formula and Steps to Calculate Net Present Value (NPV) of Internal Revenue Service: Automated Collection System

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 Acs Collection 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 Acs Collection 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 (10009048) -10009048 - -
Year 1 3470016 -6539032 3470016 0.8696 3017405
Year 2 3968552 -2570480 7438568 0.7561 3000795
Year 3 3950760 1380280 11389328 0.6575 2597689
Year 4 3243303 4623583 14632631 0.5718 1854369
TOTAL 10470259


The Net NPV after 4 years is 461211

(10470259 - 10009048 )






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 (10009048) -10009048 - -
Year 1 3470016 -6539032 3470016 0.8333 2891680
Year 2 3968552 -2570480 7438568 0.6944 2755939
Year 3 3950760 1380280 11389328 0.5787 2286319
Year 4 3243303 4623583 14632631 0.4823 1564093
TOTAL 9498031


The Net NPV after 4 years is -511017

At 20% discount rate the NPV is negative (9498031 - 10009048 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Acs Collection 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 Acs Collection has a NPV value higher than Zero then finance managers at Acs Collection 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 Acs Collection, then the stock price of the Acs Collection 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 Acs Collection 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 –

Understanding of risks involved in the project.

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

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

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.

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.




References & Further Readings

Nitin Nohria, John Chalykoff (2018), "Internal Revenue Service: Automated Collection System Harvard Business Review Case Study. Published by HBR Publications.