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Paragon Information Systems 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 Paragon Information Systems case study


At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Paragon Information Systems case study is a Harvard Business School (HBR) case study written by John R. Phillips, W. Glenn Rowe. The Paragon Information Systems (referred as “Paragon Systems” from here on) case study provides evaluation & decision scenario in field of Organizational Development. It also touches upon business topics such as - Value proposition, Competition, IT, Leadership, Organizational structure, Strategy execution.

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 Paragon Information Systems Case Study


Paragon Information Systems is a small business unit owned by NewTel Enterprises Ltd. that manufactures hardware for information technology and systems integration. The newly appointed CEO is facing a crisis. Days after his appointment, two vice-presidents resigned to start a new company. The new company recruited the entire sales team, members of the technical unit, and support staff from Paragon Information Systems--a loss of almost one third of Paragon's staff within two months. The new CEO must meet short-term stakeholder needs; assess, formulate, and implement long-term strategies; deal with the competitive threat of the new company; and consider the leadership style and control systems required to make the necessary level of change.


Case Authors : John R. Phillips, W. Glenn Rowe

Topic : Organizational Development

Related Areas : Competition, IT, Leadership, Organizational structure, Strategy execution




Calculating Net Present Value (NPV) at 6% for Paragon Information Systems Case Study


Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Discounted
Cash Flows
Year 0 (10003725) -10003725 - -
Year 1 3463458 -6540267 3463458 0.9434 3267413
Year 2 3961986 -2578281 7425444 0.89 3526153
Year 3 3939974 1361693 11365418 0.8396 3308078
Year 4 3238675 4600368 14604093 0.7921 2565334
TOTAL 14604093 12666979


The Net Present Value at 6% discount rate is 2663254

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. Profitability Index
2. Internal Rate of Return
3. Net Present Value
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. Paragon Systems 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 Paragon Systems have higher preference for cash returns over 4-5 years rather than 10-15 years given the nature of the volatility in the industry.




Formula and Steps to Calculate Net Present Value (NPV) of Paragon Information Systems

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 Paragon Systems 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 Paragon Systems 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 (10003725) -10003725 - -
Year 1 3463458 -6540267 3463458 0.8696 3011703
Year 2 3961986 -2578281 7425444 0.7561 2995831
Year 3 3939974 1361693 11365418 0.6575 2590597
Year 4 3238675 4600368 14604093 0.5718 1851723
TOTAL 10449853


The Net NPV after 4 years is 446128

(10449853 - 10003725 )






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 (10003725) -10003725 - -
Year 1 3463458 -6540267 3463458 0.8333 2886215
Year 2 3961986 -2578281 7425444 0.6944 2751379
Year 3 3939974 1361693 11365418 0.5787 2280078
Year 4 3238675 4600368 14604093 0.4823 1561861
TOTAL 9479533


The Net NPV after 4 years is -524192

At 20% discount rate the NPV is negative (9479533 - 10003725 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Paragon Systems 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 Paragon Systems has a NPV value higher than Zero then finance managers at Paragon Systems 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 Paragon Systems, then the stock price of the Paragon Systems 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 Paragon Systems 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 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.

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

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

John R. Phillips, W. Glenn Rowe (2018), "Paragon Information Systems Harvard Business Review Case Study. Published by HBR Publications.