Sondologics: Product Diversion and MAP Violations in Internet Channels 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 Sondologics: Product Diversion and MAP Violations in Internet Channels case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Sondologics: Product Diversion and MAP Violations in Internet Channels case study is a Harvard Business School (HBR) case study written by Anne Coughlan. The Sondologics: Product Diversion and MAP Violations in Internet Channels (referred as “Sondologics Gray” 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, Pricing, Product development.

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 Sondologics: Product Diversion and MAP Violations in Internet Channels Case Study

Sondologics, a manufacturer of video, audio, and gaming accessories products, was experiencing pricing and distribution problems in its channels. Numerous retailers were complaining about unfair price competition from unauthorized retailers, i.e., gray marketers, on standalone websites or Amazon's Marketplace, offering discounts of up to 30% off list price. The company estimated that about 10% of its retail volume in the United States was being generated by unauthorized retailers. Compounding the problem, gray marketers and authorized retailers alike were selling at below-list prices, which violated the Sondologics MAP (minimum advertised pricing) policy. Sondologics was considering numerous initiatives to address the MAP and gray-market problems, including retaining a third-party service to monitor pricing and distribution in the channel. Students are asked to develop recommendations that would promote sales while protecting the name-brand image and price points of Sondologics' products.

Case Authors : Anne Coughlan

Topic : Sales & Marketing

Related Areas : Marketing, Pricing, Product development

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Calculating Net Present Value (NPV) at 6% for Sondologics: Product Diversion and MAP Violations in Internet Channels Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10013319)	-10013319	-	-
Year 1	3461708	-6551611	3461708	0.9434	3265762
Year 2	3964415	-2587196	7426123	0.89	3528315
Year 3	3957295	1370099	11383418	0.8396	3322621
Year 4	3236250	4606349	14619668	0.7921	2563413
TOTAL			14619668		12680112

The Net Present Value at 6% discount rate is 2666793

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. Payback Period
2. Net Present Value
3. Profitability Index
4. Internal Rate of Return

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. Sondologics Gray 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 Sondologics Gray 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 Sondologics: Product Diversion and MAP Violations in Internet Channels

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 Sondologics Gray 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 Sondologics Gray 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	(10013319)	-10013319	-	-
Year 1	3461708	-6551611	3461708	0.8696	3010181
Year 2	3964415	-2587196	7426123	0.7561	2997667
Year 3	3957295	1370099	11383418	0.6575	2601986
Year 4	3236250	4606349	14619668	0.5718	1850336
TOTAL					10460170

The Net NPV after 4 years is 446851

(10460170 - 10013319 )

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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	(10013319)	-10013319	-	-
Year 1	3461708	-6551611	3461708	0.8333	2884757
Year 2	3964415	-2587196	7426123	0.6944	2753066
Year 3	3957295	1370099	11383418	0.5787	2290101
Year 4	3236250	4606349	14619668	0.4823	1560692
TOTAL					9488615

The Net NPV after 4 years is -524704

At 20% discount rate the NPV is negative (9488615 - 10013319 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Sondologics Gray 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 Sondologics Gray has a NPV value higher than Zero then finance managers at Sondologics Gray 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 Sondologics Gray, then the stock price of the Sondologics Gray 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 Sondologics Gray 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 can impact the cash flow of the project.

Understanding of risks involved in the project.

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

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 Sondologics: Product Diversion and MAP Violations in Internet Channels

References & Further Readings

Anne Coughlan (2018), "Sondologics: Product Diversion and MAP Violations in Internet Channels Harvard Business Review Case Study. Published by HBR Publications.