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. Zuji: Finding a Winning Strategy case study is a Harvard Business School (HBR) case study written by Kevin Zhou, Josephine Lau. The Zuji: Finding a Winning Strategy (referred as “Zuji Kong” 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, Mobile.
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.
It was October 2015, Charlie Wong, CEO of Zuji Hong Kong told the media at the launch of Zuji's new brand campaign "Search, Discover and Share" that he would like to see Zuji "become the Google for travel" in Hong Kong. Indeed, a deemed pioneer and leading online travel agent ("OTA") in Hong Kong, the aspiration did not seem far-fetched. Yet, the ambition was not without challenge. Since Zuji went online in 2002, the brand had been twice sold and its geographic coverage shrunk from six to three markets: Hong Kong, Singapore and Australia. Online travel booking had been slow picking up in Hong Kong. After more than 10 years, online sales remained at under 10% of the total market in Hong Kong, compared to the regional average of 25% in Asia Pacific. As momentum built up, Wong predicted the online travel agent ("OTA") market to quadruple, from 10% in 2014 to 40% in 2016. Meantime, competition from multiple fronts was flooding the market. Global leader Expedia had launched Expedia.com.hk in 2013, and was investing heavily in marketing to capture share. Traditional offline agents were busy expanding their online presence, building a hybrid model as competitive advantage. At the consumer end, mobile phones have become an indispensable travel companion and its implication went beyond the migration from one platform to another. Around the world, the industry was seeing the rise of the millennia travellers with new needs and expectations while on the road, and they were changing the rules of the game. Zuji is facing the biggest opportunity of its time to ride this wave of change and reinforced its market leadership.
| Years | Cash Flow | Net Cash Flow | Cumulative Cash Flow |
Discount Rate @ 6 % |
Discounted Cash Flows |
|---|---|---|---|---|---|
| Year 0 | (10001206) | -10001206 | - | - | |
| Year 1 | 3464873 | -6536333 | 3464873 | 0.9434 | 3268748 |
| Year 2 | 3953566 | -2582767 | 7418439 | 0.89 | 3518660 |
| Year 3 | 3975721 | 1392954 | 11394160 | 0.8396 | 3338092 |
| Year 4 | 3228415 | 4621369 | 14622575 | 0.7921 | 2557207 |
| TOTAL | 14622575 | 12682707 |
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. Profitability Index
3. Payback Period
4. Net Present Value
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. Zuji Kong 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 Zuji Kong have higher preference for cash returns over 4-5 years rather than 10-15 years given the nature of the volatility in the industry.
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 Zuji Kong 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 Zuji Kong 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 | (10001206) | -10001206 | - | - | |
| Year 1 | 3464873 | -6536333 | 3464873 | 0.8696 | 3012933 |
| Year 2 | 3953566 | -2582767 | 7418439 | 0.7561 | 2989464 |
| Year 3 | 3975721 | 1392954 | 11394160 | 0.6575 | 2614101 |
| Year 4 | 3228415 | 4621369 | 14622575 | 0.5718 | 1845857 |
| TOTAL | 10462355 |
(10462355 - 10001206 )
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 | (10001206) | -10001206 | - | - | |
| Year 1 | 3464873 | -6536333 | 3464873 | 0.8333 | 2887394 |
| Year 2 | 3953566 | -2582767 | 7418439 | 0.6944 | 2745532 |
| Year 3 | 3975721 | 1392954 | 11394160 | 0.5787 | 2300764 |
| Year 4 | 3228415 | 4621369 | 14622575 | 0.4823 | 1556913 |
| TOTAL | 9490604 |
At 20% discount rate the NPV is negative (9490604 - 10001206 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Zuji Kong to discount cash flow at lower discount rates such as 15%.
Simplest Approach – If the investment project of Zuji Kong has a NPV value higher than Zero then finance managers at Zuji Kong 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 Zuji Kong, then the stock price of the Zuji Kong 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 Zuji Kong 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.
Understanding of risks involved in the project.
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 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.
Kevin Zhou, Josephine Lau (2018), "Zuji: Finding a Winning Strategy Harvard Business Review Case Study. Published by HBR Publications.
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