Kit Hindrichs at Pentagram (B) 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 Kit Hindrichs at Pentagram (B) case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Kit Hindrichs at Pentagram (B) case study is a Harvard Business School (HBR) case study written by Linda A. Hill, Emily A. Stecker. The Kit Hindrichs at Pentagram (B) (referred as “Pentagram Hindrichs” 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.

NPV = Present Value of Future Cash Flows LESS Project’s Initial Investment

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Case Description of Kit Hindrichs at Pentagram (B) Case Study

This case focuses on Kit Hindrichs, 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 describes how Hinrichs grapples with the future of the San Francisco office, once learning he will be its only partner.

Case Authors : Linda A. Hill, Emily A. Stecker

Topic : Organizational Development

Related Areas : Collaboration, Creativity, Diversity, Organizational structure

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Calculating Net Present Value (NPV) at 6% for Kit Hindrichs at Pentagram (B) Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10013005)	-10013005	-	-
Year 1	3467849	-6545156	3467849	0.9434	3271556
Year 2	3979318	-2565838	7447167	0.89	3541579
Year 3	3971326	1405488	11418493	0.8396	3334402
Year 4	3243104	4648592	14661597	0.7921	2568842
TOTAL			14661597		12716379

The Net Present Value at 6% discount rate is 2703374

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. Payback Period
2. Profitability Index
3. Net Present Value
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. Timing of the expected cash flows – stockholders of Pentagram Hindrichs 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 Hindrichs shareholders have preference for diversified projects investment rather than prospective high income from a single capital intensive project.

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Formula and Steps to Calculate Net Present Value (NPV) of Kit Hindrichs at Pentagram (B)

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 Pentagram Hindrichs 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 Hindrichs 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	(10013005)	-10013005	-	-
Year 1	3467849	-6545156	3467849	0.8696	3015521
Year 2	3979318	-2565838	7447167	0.7561	3008936
Year 3	3971326	1405488	11418493	0.6575	2611211
Year 4	3243104	4648592	14661597	0.5718	1854255
TOTAL					10489924

The Net NPV after 4 years is 476919

(10489924 - 10013005 )

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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	(10013005)	-10013005	-	-
Year 1	3467849	-6545156	3467849	0.8333	2889874
Year 2	3979318	-2565838	7447167	0.6944	2763415
Year 3	3971326	1405488	11418493	0.5787	2298221
Year 4	3243104	4648592	14661597	0.4823	1563997
TOTAL					9515507

The Net NPV after 4 years is -497498

At 20% discount rate the NPV is negative (9515507 - 10013005 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Pentagram Hindrichs 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 Pentagram Hindrichs has a NPV value higher than Zero then finance managers at Pentagram Hindrichs 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 Hindrichs, then the stock price of the Pentagram Hindrichs 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 Pentagram Hindrichs 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 can impact the cash flow of 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 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.

Understanding of risks involved in 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 Kit Hindrichs at Pentagram (B)

References & Further Readings

Linda A. Hill, Emily A. Stecker (2018), "Kit Hindrichs at Pentagram (B) Harvard Business Review Case Study. Published by HBR Publications.