The Motor City: Rebuilding Detroit's Image Post-bankruptcy 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 The Motor City: Rebuilding Detroit's Image Post-bankruptcy case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. The Motor City: Rebuilding Detroit's Image Post-bankruptcy case study is a Harvard Business School (HBR) case study written by Dante Pirouz, Karam Putros, Nithiyaa Pushpanathan. The The Motor City: Rebuilding Detroit's Image Post-bankruptcy (referred as “City Detroit” from here on) case study provides evaluation & decision scenario in field of Sales & Marketing. It also touches upon business topics such as - Value proposition, Government.

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 The Motor City: Rebuilding Detroit's Image Post-bankruptcy Case Study

Rebranding is a marketing strategy often used by companies. The rebranding of a city is not only less common but far more complex. By 2013, the city of Detroit, Michigan was facing a multitude of problems: declining population, crumbling roads and bridges, abandoned properties, an alarming school drop-out rate, poverty, high cost of pension plans, government corruption, growing crime and crippled emergency services. The 2008 recession had dealt a serious blow to its core automotive industrial sector, and although some high tech companies were moving in, the "Motor City" was wallowing in debt. In July 2013, Detroit filed for bankruptcy protection, which was granted that December. Its financial emergency manager was able to strike deals with its major debt-holders, the banks, and with the city's largest union, but these forward steps were threatened when the water department started cutting off water to households that could not pay bills that had risen 120 per cent over the past decade. How does a city facing outraged residents and investors, that lacks infrastructure to such a degree that almost half of its traffic lights are non-functional and that is in an atrocious financial state repair its image and attract new investors?

Case Authors : Dante Pirouz, Karam Putros, Nithiyaa Pushpanathan

Topic : Sales & Marketing

Related Areas : Government

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Calculating Net Present Value (NPV) at 6% for The Motor City: Rebuilding Detroit's Image Post-bankruptcy Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10017087)	-10017087	-	-
Year 1	3464288	-6552799	3464288	0.9434	3268196
Year 2	3966666	-2586133	7430954	0.89	3530319
Year 3	3958903	1372770	11389857	0.8396	3323971
Year 4	3233703	4606473	14623560	0.7921	2561396
TOTAL			14623560		12683882

The Net Present Value at 6% discount rate is 2666795

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. Internal Rate of Return
2. Net Present Value
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. Timing of the expected cash flows – stockholders of City Detroit 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. City Detroit 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 The Motor City: Rebuilding Detroit's Image Post-bankruptcy

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 City Detroit 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 City Detroit 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	(10017087)	-10017087	-	-
Year 1	3464288	-6552799	3464288	0.8696	3012424
Year 2	3966666	-2586133	7430954	0.7561	2999369
Year 3	3958903	1372770	11389857	0.6575	2603043
Year 4	3233703	4606473	14623560	0.5718	1848880
TOTAL					10463717

The Net NPV after 4 years is 446630

(10463717 - 10017087 )

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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	(10017087)	-10017087	-	-
Year 1	3464288	-6552799	3464288	0.8333	2886907
Year 2	3966666	-2586133	7430954	0.6944	2754629
Year 3	3958903	1372770	11389857	0.5787	2291032
Year 4	3233703	4606473	14623560	0.4823	1559463
TOTAL					9492031

The Net NPV after 4 years is -525056

At 20% discount rate the NPV is negative (9492031 - 10017087 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of City Detroit 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 City Detroit has a NPV value higher than Zero then finance managers at City Detroit 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 City Detroit, then the stock price of the City Detroit 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 City Detroit 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.

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

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 The Motor City: Rebuilding Detroit's Image Post-bankruptcy

References & Further Readings

Dante Pirouz, Karam Putros, Nithiyaa Pushpanathan (2018), "The Motor City: Rebuilding Detroit's Image Post-bankruptcy Harvard Business Review Case Study. Published by HBR Publications.