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. Royal DSM (A): Creating a Chief Marketing Officer (CMO) Position in a B2B Firm case study is a Harvard Business School (HBR) case study written by Wolfgang Ulaga, Athanasios Kondis. The Royal DSM (A): Creating a Chief Marketing Officer (CMO) Position in a B2B Firm (referred as “Adade Cmo” from here on) case study provides evaluation & decision scenario in field of Sales & Marketing. It also touches upon business topics such as - Value proposition, Change management, Marketing.
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 three-part case series examines the change management challenge of putting corporate marketing at the top of the corporate executive suite (C-suite) agenda in a business-to-business (B2B) multinational. It follows the four-year journey, from 2010 to 2014, of Mauricio Adade, the newly appointed chief marketing officer (CMO) of Royal DSM - a global leader in life sciences and material sciences headquartered in the Netherlands. The case series, together with the video supplement, delves into the issues faced by the company's top leadership, including Adade, in its effort to transform a diversified industrial company into an organization with best-in-class marketing and sales capabilities. Case A begins by highlighting the culture and organizational structure of Royal DSM and the decision to raise the profile of headquarters-based corporate marketing, with the appointment of Adade in 2010. It discusses the marketing and sales excellence project launched by the new CMO during his first year at the helm and concludes by putting the spotlight on the resistance posed by the company's most powerful stakeholders: the business group leaders. Case B focuses on the implementation journey during the period 2011-2014. Adade and his team adopted a new plan of action and positioned the corporate marketing department as a partner that worked with the business groups to deliver projects with quantifiable results. Did the new strategy work? Case C provides an update on the replacement of Adade (announced in December 2014) and allows for a discussion on the challenges that lie ahead for the new CMO and the organization as a whole.
| Years | Cash Flow | Net Cash Flow | Cumulative Cash Flow |
Discount Rate @ 6 % |
Discounted Cash Flows |
|---|---|---|---|---|---|
| Year 0 | (10019719) | -10019719 | - | - | |
| Year 1 | 3471487 | -6548232 | 3471487 | 0.9434 | 3274988 |
| Year 2 | 3964505 | -2583727 | 7435992 | 0.89 | 3528395 |
| Year 3 | 3971294 | 1387567 | 11407286 | 0.8396 | 3334375 |
| Year 4 | 3242116 | 4629683 | 14649402 | 0.7921 | 2568060 |
| TOTAL | 14649402 | 12705818 |
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. Internal Rate of Return
2. Payback Period
3. Net Present Value
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. Timing of the expected cash flows – stockholders of Adade Cmo 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. Adade Cmo 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 Adade Cmo 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 Adade Cmo 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 | (10019719) | -10019719 | - | - | |
| Year 1 | 3471487 | -6548232 | 3471487 | 0.8696 | 3018684 |
| Year 2 | 3964505 | -2583727 | 7435992 | 0.7561 | 2997735 |
| Year 3 | 3971294 | 1387567 | 11407286 | 0.6575 | 2611190 |
| Year 4 | 3242116 | 4629683 | 14649402 | 0.5718 | 1853690 |
| TOTAL | 10481300 |
(10481300 - 10019719 )
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 | (10019719) | -10019719 | - | - | |
| Year 1 | 3471487 | -6548232 | 3471487 | 0.8333 | 2892906 |
| Year 2 | 3964505 | -2583727 | 7435992 | 0.6944 | 2753128 |
| Year 3 | 3971294 | 1387567 | 11407286 | 0.5787 | 2298203 |
| Year 4 | 3242116 | 4629683 | 14649402 | 0.4823 | 1563520 |
| TOTAL | 9507757 |
At 20% discount rate the NPV is negative (9507757 - 10019719 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Adade Cmo to discount cash flow at lower discount rates such as 15%.
Simplest Approach – If the investment project of Adade Cmo has a NPV value higher than Zero then finance managers at Adade Cmo 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 Adade Cmo, then the stock price of the Adade Cmo 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 Adade Cmo 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 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.
What are the key aspects of the projects that need to be monitored, refined, and retuned for continuous delivery of projected cash flows.
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.
Wolfgang Ulaga, Athanasios Kondis (2018), "Royal DSM (A): Creating a Chief Marketing Officer (CMO) Position in a B2B Firm Harvard Business Review Case Study. Published by HBR Publications.
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