Future of Avon's China: Direct Sales, Retail Sales or Both 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 Future of Avon's China: Direct Sales, Retail Sales or Both case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Future of Avon's China: Direct Sales, Retail Sales or Both case study is a Harvard Business School (HBR) case study written by Zhigang Tao, Dongya Li, Isabella Chan. The Future of Avon's China: Direct Sales, Retail Sales or Both (referred as “Avon Direct” from here on) case study provides evaluation & decision scenario in field of Sales & Marketing. It also touches upon business topics such as - Value proposition, Emerging markets, Marketing, Sales.

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 Future of Avon's China: Direct Sales, Retail Sales or Both Case Study

On 9 April 2005, the leading global direct-sales cosmetics company, Avon, gained exclusive rights from the Chinese government to test the direct-selling model in China. This provided Avon a rare opportunity to expand its business, especially given that the demand for cosmetics in China had skyrocketed in the past decades. Since China banned the direct sales model in 1998, Avon had successfully adopted the traditional sales model of boutique and counter stores. Although the direct sales model had worked well for Avon in almost all other markets in the world, the traditional sales model had proved to be very successful in China. How should Avon exploit this opportunity of direct selling in China?

Case Authors : Zhigang Tao, Dongya Li, Isabella Chan

Topic : Sales & Marketing

Related Areas : Emerging markets, Marketing, Sales

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Calculating Net Present Value (NPV) at 6% for Future of Avon's China: Direct Sales, Retail Sales or Both Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10025316)	-10025316	-	-
Year 1	3460337	-6564979	3460337	0.9434	3264469
Year 2	3954612	-2610367	7414949	0.89	3519591
Year 3	3958327	1347960	11373276	0.8396	3323488
Year 4	3249199	4597159	14622475	0.7921	2573670
TOTAL			14622475		12681217

The Net Present Value at 6% discount rate is 2655901

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. Internal Rate of Return
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. Avon Direct 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 Avon Direct 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 Future of Avon's China: Direct Sales, Retail Sales or Both

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 Avon Direct 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 Avon Direct 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	(10025316)	-10025316	-	-
Year 1	3460337	-6564979	3460337	0.8696	3008989
Year 2	3954612	-2610367	7414949	0.7561	2990255
Year 3	3958327	1347960	11373276	0.6575	2602664
Year 4	3249199	4597159	14622475	0.5718	1857740
TOTAL					10459648

The Net NPV after 4 years is 434332

(10459648 - 10025316 )

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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	(10025316)	-10025316	-	-
Year 1	3460337	-6564979	3460337	0.8333	2883614
Year 2	3954612	-2610367	7414949	0.6944	2746258
Year 3	3958327	1347960	11373276	0.5787	2290698
Year 4	3249199	4597159	14622475	0.4823	1566936
TOTAL					9487507

The Net NPV after 4 years is -537809

At 20% discount rate the NPV is negative (9487507 - 10025316 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Avon Direct 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 Avon Direct has a NPV value higher than Zero then finance managers at Avon Direct 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 Avon Direct, then the stock price of the Avon Direct 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 Avon Direct 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 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.

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 Future of Avon's China: Direct Sales, Retail Sales or Both

References & Further Readings

Zhigang Tao, Dongya Li, Isabella Chan (2018), "Future of Avon's China: Direct Sales, Retail Sales or Both Harvard Business Review Case Study. Published by HBR Publications.