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. Kit Hinrichs at Pentagram (A) case study is a Harvard Business School (HBR) case study written by Linda A. Hill, Emily A. Stecker. The Kit Hinrichs at Pentagram (A) (referred as “Pentagram Hinrichs” from here on) case study provides evaluation & decision scenario in field of Organizational Development. It also touches upon business topics such as - Value proposition, Collaboration, Creativity, Diversity, Organizational structure.
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.
This case focuses on Kit Hinrichs, a 65 year-old partner at Pentagram, a privately-owned multidisciplinary design firm. One of the world's most prestigious design firms, Pentagram was founded by five designers from different disciplines in London in the 1970s. By 2008, Pentagram remained small, with less than 30 partners, each a veritable star in his or her own right. Pentagram had two founding principles, the first of which was equality. The equality principle meant that leadership was evenly distributed; partners with seniority had no greater formal authority than newer partners, and the only formal leadership role was a chairman position, which, after being held with a founder for 30 years, was rotated every two years. Further, Pentagram had no corporate office; each partner was expected to manage their own financial, marketing, and human resource functions. Pentagram's second principle was generosity. All partners were equal shareholders in the firm. Pentagram branched out to New York in the early 1980s, and in the late 1980s, Hinrichs established a San Francisco location. This case traces Hinrichs as he builds Pentagram's San Francisco office, and it also details the evolution of Pentagram itself. In addition, this case offers a thick description of Hinrichs and his team working with a client. This case can be used in business and executive education courses on professional service firms, leading a creative organization, and the role of design in business. It should also be used by schools of design.
| Years | Cash Flow | Net Cash Flow | Cumulative Cash Flow |
Discount Rate @ 6 % |
Discounted Cash Flows |
|---|---|---|---|---|---|
| Year 0 | (10023184) | -10023184 | - | - | |
| Year 1 | 3443588 | -6579596 | 3443588 | 0.9434 | 3248668 |
| Year 2 | 3975503 | -2604093 | 7419091 | 0.89 | 3538184 |
| Year 3 | 3946355 | 1342262 | 11365446 | 0.8396 | 3313436 |
| Year 4 | 3251284 | 4593546 | 14616730 | 0.7921 | 2575321 |
| TOTAL | 14616730 | 12675609 |
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. Net Present Value
2. Payback Period
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 Pentagram Hinrichs 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. Pentagram Hinrichs shareholders have preference for diversified projects investment rather than prospective high income from a single capital intensive project.
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 Pentagram Hinrichs 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 Pentagram Hinrichs 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 | (10023184) | -10023184 | - | - | |
| Year 1 | 3443588 | -6579596 | 3443588 | 0.8696 | 2994424 |
| Year 2 | 3975503 | -2604093 | 7419091 | 0.7561 | 3006051 |
| Year 3 | 3946355 | 1342262 | 11365446 | 0.6575 | 2594792 |
| Year 4 | 3251284 | 4593546 | 14616730 | 0.5718 | 1858932 |
| TOTAL | 10454200 |
(10454200 - 10023184 )
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 | (10023184) | -10023184 | - | - | |
| Year 1 | 3443588 | -6579596 | 3443588 | 0.8333 | 2869657 |
| Year 2 | 3975503 | -2604093 | 7419091 | 0.6944 | 2760766 |
| Year 3 | 3946355 | 1342262 | 11365446 | 0.5787 | 2283770 |
| Year 4 | 3251284 | 4593546 | 14616730 | 0.4823 | 1567942 |
| TOTAL | 9482135 |
At 20% discount rate the NPV is negative (9482135 - 10023184 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Pentagram Hinrichs to discount cash flow at lower discount rates such as 15%.
Simplest Approach – If the investment project of Pentagram Hinrichs has a NPV value higher than Zero then finance managers at Pentagram Hinrichs 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 Pentagram Hinrichs, then the stock price of the Pentagram Hinrichs 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 Pentagram Hinrichs 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.
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.
Linda A. Hill, Emily A. Stecker (2018), "Kit Hinrichs at Pentagram (A) Harvard Business Review Case Study. Published by HBR Publications.
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