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. Unleashing Organizational Energy case study is a Harvard Business School (HBR) case study written by Heike Bruch, Sumantra Ghoshal. The Unleashing Organizational Energy (referred as “Energy Zone” from here on) case study provides evaluation & decision scenario in field of Organizational Development. It also touches upon business topics such as - Value proposition, Human resource management, Leadership, Organizational culture.
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 is an MIT Sloan Management Review article. Long-term research conducted with companies such as ABB and Lufthansa has helped the authors identify four organizational energy zones that, harnessed properly, can provide a powerful boost for achieving strategic goals. The researchers offer insight on selecting the type best suited to a company's culture and its leaders' personal styles. They find that analytical approaches to management are increasingly incorporating a greater understanding of the major role that emotions play in corporate behavior. Today's challenge for leaders, the authors say, is to ensure that the company's vision and strategy capture employees' excitement, engage their intellect, and fill them with an urgency for action taking. First, they show that companies operating in what they call the aggression zone (responding to a threat) or the passion zone (responding to an exciting goal) are more likely to be successful. Companies in the low-energy comfort zone coast dangerously on past success, and those in the resignation zone have nearly given up. Second, they describe two strategies for unleashing organizational energy and the circumstances that indicate which to use. Finally, they point out ways to avoid common energy traps. Without a high level of energy, the authors contend, a company cannot achieve radical productivity improvements, grow fast, or create major innovations. The researchers give examples of enlightened managers who are focusing on unleashing that energy and are leading their companies to outstanding performance.
| Years | Cash Flow | Net Cash Flow | Cumulative Cash Flow |
Discount Rate @ 6 % |
Discounted Cash Flows |
|---|---|---|---|---|---|
| Year 0 | (10026696) | -10026696 | - | - | |
| Year 1 | 3447077 | -6579619 | 3447077 | 0.9434 | 3251959 |
| Year 2 | 3956707 | -2622912 | 7403784 | 0.89 | 3521455 |
| Year 3 | 3960581 | 1337669 | 11364365 | 0.8396 | 3325380 |
| Year 4 | 3233672 | 4571341 | 14598037 | 0.7921 | 2561371 |
| TOTAL | 14598037 | 12660166 |
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. Profitability Index
2. Payback Period
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 Energy Zone 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. Energy Zone 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 Energy Zone 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 Energy Zone 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 | (10026696) | -10026696 | - | - | |
| Year 1 | 3447077 | -6579619 | 3447077 | 0.8696 | 2997458 |
| Year 2 | 3956707 | -2622912 | 7403784 | 0.7561 | 2991839 |
| Year 3 | 3960581 | 1337669 | 11364365 | 0.6575 | 2604146 |
| Year 4 | 3233672 | 4571341 | 14598037 | 0.5718 | 1848862 |
| TOTAL | 10442306 |
(10442306 - 10026696 )
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 | (10026696) | -10026696 | - | - | |
| Year 1 | 3447077 | -6579619 | 3447077 | 0.8333 | 2872564 |
| Year 2 | 3956707 | -2622912 | 7403784 | 0.6944 | 2747713 |
| Year 3 | 3960581 | 1337669 | 11364365 | 0.5787 | 2292003 |
| Year 4 | 3233672 | 4571341 | 14598037 | 0.4823 | 1559448 |
| TOTAL | 9471729 |
At 20% discount rate the NPV is negative (9471729 - 10026696 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Energy Zone to discount cash flow at lower discount rates such as 15%.
Simplest Approach – If the investment project of Energy Zone has a NPV value higher than Zero then finance managers at Energy Zone 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 Energy Zone, then the stock price of the Energy Zone 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 Energy Zone 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 are the key aspects of the projects that need to be monitored, refined, and retuned for continuous delivery of projected cash flows.
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.
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.
Heike Bruch, Sumantra Ghoshal (2018), "Unleashing Organizational Energy Harvard Business Review Case Study. Published by HBR Publications.
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