Reverend Musical Instruments: Playing a Different Tune (B) 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 Reverend Musical Instruments: Playing a Different Tune (B) case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Reverend Musical Instruments: Playing a Different Tune (B) case study is a Harvard Business School (HBR) case study written by Mark Hunter, David A. Soberman. The Reverend Musical Instruments: Playing a Different Tune (B) (referred as “Instruments Guitar” from here on) case study provides evaluation & decision scenario in field of Sales & Marketing. It also touches upon business topics such as - Value proposition, .

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 Reverend Musical Instruments: Playing a Different Tune (B) Case Study

The electric guitar market is both enticing and daunting for a small company - a multi-billion $US sector that has grown almost constantly since the 1960s, but where competition is based as much on image as on substance. The market is naturally fragmented (similar to the market for many musical instruments), yet dominant players make entry and sustenance difficult. While Asian producers or branded imports dominate the low and mid-priced market, collectors and serious players seek high-end branded or handmade instruments that can be resold with only minor loss, if any. To augment collector value, high-end guitar manufacturers constantly modify components, making short-run series with unique features (often specified by "name" musicians and sold under their signature). For established brands, vintage instruments, and handmade instruments, used guitars may sell for their original purchase price or surprising multiples thereof; the value of some pieces increases after only ten years. From this standpoint, experienced buyers can make essentially risk-free purchases. The case tells the story of Joe Naylor, the owner-manager of Reverend Guitars, a small company that made a startling impact on the electric guitar market with a clever use of innovative products, innovative marketing and innovative use of the internet to a) leverage an existing community and b) build a new one.

Case Authors : Mark Hunter, David A. Soberman

Topic : Sales & Marketing

Related Areas :

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Calculating Net Present Value (NPV) at 6% for Reverend Musical Instruments: Playing a Different Tune (B) Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10021848)	-10021848	-	-
Year 1	3460869	-6560979	3460869	0.9434	3264971
Year 2	3967443	-2593536	7428312	0.89	3531010
Year 3	3957473	1363937	11385785	0.8396	3322771
Year 4	3242665	4606602	14628450	0.7921	2568494
TOTAL			14628450		12687246

The Net Present Value at 6% discount rate is 2665398

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. Profitability Index
2. Net Present Value
3. Internal Rate of Return
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. Instruments Guitar 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 Instruments Guitar 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 Reverend Musical Instruments: Playing a Different Tune (B)

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 Instruments Guitar 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 Instruments Guitar 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	(10021848)	-10021848	-	-
Year 1	3460869	-6560979	3460869	0.8696	3009451
Year 2	3967443	-2593536	7428312	0.7561	2999957
Year 3	3957473	1363937	11385785	0.6575	2602103
Year 4	3242665	4606602	14628450	0.5718	1854004
TOTAL					10465515

The Net NPV after 4 years is 443667

(10465515 - 10021848 )

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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	(10021848)	-10021848	-	-
Year 1	3460869	-6560979	3460869	0.8333	2884058
Year 2	3967443	-2593536	7428312	0.6944	2755169
Year 3	3957473	1363937	11385785	0.5787	2290204
Year 4	3242665	4606602	14628450	0.4823	1563785
TOTAL					9493216

The Net NPV after 4 years is -528632

At 20% discount rate the NPV is negative (9493216 - 10021848 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Instruments Guitar 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 Instruments Guitar has a NPV value higher than Zero then finance managers at Instruments Guitar 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 Instruments Guitar, then the stock price of the Instruments Guitar 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 Instruments Guitar 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 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.

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.

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 Reverend Musical Instruments: Playing a Different Tune (B)

References & Further Readings

Mark Hunter, David A. Soberman (2018), "Reverend Musical Instruments: Playing a Different Tune (B) Harvard Business Review Case Study. Published by HBR Publications.