RONA Inc.- Dealing with Recession 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 RONA Inc.- Dealing with Recession case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. RONA Inc.- Dealing with Recession case study is a Harvard Business School (HBR) case study written by Darren Meister, Chandra Sekhar Ramasastry. The RONA Inc.- Dealing with Recession (referred as “Rona Recovery” from here on) case study provides evaluation & decision scenario in field of Sales & Marketing. It also touches upon business topics such as - Value proposition, Marketing, Recession, Strategy.

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 RONA Inc.- Dealing with Recession Case Study

In September 2009, the president and chief executive officer (CEO) of Rona Inc. was reviewing the company's progress in relation to the ongoing economic recession. Rona was the largest retailer of hardlines in Canada. Rona had noticed definitive signs of slowdown in the third quarter of 2007 and had launched Strategic Plan 2008 - 2011 as a response. The two-phase program was nearing the completion of its first phase of Productivity, Efficiency and Profitability (PEP) and was gearing up for the 24 month-long Recovery Program. The Strategic Plan had been tweaked since its launch, all with a view towards strengthening the core platform. The objective of the Recovery Plan was to restore focus on growth vectors from which the company had become distracted. On the eve of commencement of the Recovery Plan, the CEO began to wonder if Rona was ready to act on increasing sales, recruiting independents, constructing new stores and pursuing acquisitions. Or was it necessary to redesign and relaunch the PEP program, thus deferring the Recovery Plan?

Case Authors : Darren Meister, Chandra Sekhar Ramasastry

Topic : Sales & Marketing

Related Areas : Marketing, Recession, Strategy

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Calculating Net Present Value (NPV) at 6% for RONA Inc.- Dealing with Recession Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10011712)	-10011712	-	-
Year 1	3466613	-6545099	3466613	0.9434	3270390
Year 2	3975104	-2569995	7441717	0.89	3537828
Year 3	3946787	1376792	11388504	0.8396	3313798
Year 4	3230746	4607538	14619250	0.7921	2559053
TOTAL			14619250		12681070

The Net Present Value at 6% discount rate is 2669358

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. 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. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Rona Recovery 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 Rona Recovery have higher preference for cash returns over 4-5 years rather than 10-15 years given the nature of the volatility in the industry.

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Formula and Steps to Calculate Net Present Value (NPV) of RONA Inc.- Dealing with Recession

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 Sales & Marketing 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 Rona Recovery 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 Rona Recovery 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	(10011712)	-10011712	-	-
Year 1	3466613	-6545099	3466613	0.8696	3014446
Year 2	3975104	-2569995	7441717	0.7561	3005750
Year 3	3946787	1376792	11388504	0.6575	2595077
Year 4	3230746	4607538	14619250	0.5718	1847190
TOTAL					10462462

The Net NPV after 4 years is 450750

(10462462 - 10011712 )

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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	(10011712)	-10011712	-	-
Year 1	3466613	-6545099	3466613	0.8333	2888844
Year 2	3975104	-2569995	7441717	0.6944	2760489
Year 3	3946787	1376792	11388504	0.5787	2284020
Year 4	3230746	4607538	14619250	0.4823	1558037
TOTAL					9491391

The Net NPV after 4 years is -520321

At 20% discount rate the NPV is negative (9491391 - 10011712 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Rona Recovery 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 Rona Recovery has a NPV value higher than Zero then finance managers at Rona Recovery 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 Rona Recovery, then the stock price of the Rona Recovery 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 Rona Recovery 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 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 are the key aspects of the projects that need to be monitored, refined, and retuned for continuous delivery of projected cash flows.

What will be a multi year spillover effect of various taxation regulations.

What can impact the cash flow of the project.

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 RONA Inc.- Dealing with Recession

References & Further Readings

Darren Meister, Chandra Sekhar Ramasastry (2018), "RONA Inc.- Dealing with Recession Harvard Business Review Case Study. Published by HBR Publications.