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. Buro Happold (Abridged) case study is a Harvard Business School (HBR) case study written by Robert G. Eccles, Ryan Johnson. The Buro Happold (Abridged) (referred as “Buro Happold” from here on) case study provides evaluation & decision scenario in field of Organizational Development. It also touches upon business topics such as - Value proposition, Developing employees, Entrepreneurship, Growth strategy, International business, Leadership, Leadership development, Organizational structure, Risk management.
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 1996, Ted Happold, the founder of the engineering services firm Buro Happold passed away and Padraic Kelly became the firm's new Managing Director (MD). One of his first initiatives was "Aim for Growth" which was intended to help the firm grow beyond its current size where it was constrained by a structure of having each of the firm's founding partners responsible for a group of 25-30 engineers. This initiative was very successful but the firm then found itself with a lack of leadership skills at all levels of the organization to manage a company of a much larger size, growing by a factor of 10 over 10 years. The lack of leadership skills was recognized by clients who gave the firm feedback on this. In response, Buro Happold developed its first formal internal training programs under the name of "Archimedes Academy." The first two programs were: (1) the Job Leader Program, targeted for senior engineers and designed to help them be more effective in working with clients, and (2) the Project Leader Program, targeted for project leaders and designed to help them develop the "softer" management skills to complement their technical ones. A distinctive aspect of Archimedes Academy is that these first programs were developed and delivered by the cohorts who first attended them. Rather than partner with a university to develop an accredited program, the firm decided it would be better off developing the program itself, with the help of an outside consultant who had done something similar at his previous employer, in order to make sure the programs were specific enough to Buro Happold's needs and relevant to the firm's culture. The first two programs were a big success and the firm expanded the training offerings under the Archimedes Banner. The case ends with a client, a Middle Eastern city authority, asking Buro Happold Consulting, a new unit created by Padraid Kelly after stepping down as MD in 2006, asking the firm to develop a training program for them. This request raises the question of whether this internal training capability should become the basis of an external service offering.
| Years | Cash Flow | Net Cash Flow | Cumulative Cash Flow |
Discount Rate @ 6 % |
Discounted Cash Flows |
|---|---|---|---|---|---|
| Year 0 | (10005347) | -10005347 | - | - | |
| Year 1 | 3471782 | -6533565 | 3471782 | 0.9434 | 3275266 |
| Year 2 | 3972574 | -2560991 | 7444356 | 0.89 | 3535577 |
| Year 3 | 3950514 | 1389523 | 11394870 | 0.8396 | 3316928 |
| Year 4 | 3222344 | 4611867 | 14617214 | 0.7921 | 2552398 |
| TOTAL | 14617214 | 12680169 |
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. Internal Rate of Return
3. Profitability Index
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. Buro Happold 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 Buro Happold 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 Buro Happold 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 Buro Happold 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 | (10005347) | -10005347 | - | - | |
| Year 1 | 3471782 | -6533565 | 3471782 | 0.8696 | 3018941 |
| Year 2 | 3972574 | -2560991 | 7444356 | 0.7561 | 3003837 |
| Year 3 | 3950514 | 1389523 | 11394870 | 0.6575 | 2597527 |
| Year 4 | 3222344 | 4611867 | 14617214 | 0.5718 | 1842386 |
| TOTAL | 10462690 |
(10462690 - 10005347 )
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 | (10005347) | -10005347 | - | - | |
| Year 1 | 3471782 | -6533565 | 3471782 | 0.8333 | 2893152 |
| Year 2 | 3972574 | -2560991 | 7444356 | 0.6944 | 2758732 |
| Year 3 | 3950514 | 1389523 | 11394870 | 0.5787 | 2286177 |
| Year 4 | 3222344 | 4611867 | 14617214 | 0.4823 | 1553985 |
| TOTAL | 9492046 |
At 20% discount rate the NPV is negative (9492046 - 10005347 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Buro Happold to discount cash flow at lower discount rates such as 15%.
Simplest Approach – If the investment project of Buro Happold has a NPV value higher than Zero then finance managers at Buro Happold 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 Buro Happold, then the stock price of the Buro Happold 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 Buro Happold 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 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.
Understanding of risks involved in the project.
What will be a multi year spillover effect of various taxation regulations.
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.
Robert G. Eccles, Ryan Johnson (2018), "Buro Happold (Abridged) Harvard Business Review Case Study. Published by HBR Publications.
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