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. Markdown Optimization for an Indian Apparel Retailer case study is a Harvard Business School (HBR) case study written by Deepak George, Karthik Kuram, Ramalakshmi Subramanian, Sumad Singh. The Markdown Optimization for an Indian Apparel Retailer (referred as “Eoss Markdown” 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.
Siddharth Sinha is the CEO of an apparel retailer WE SELL STYLE (WSS). The retail chain was set up in 2008, housing more than 100 brands. In 2015, they operated over 200 stores in all four regions of the country. They primarily focused on providing good quality fashion at a remarkably low price. Markdown planning has been an important aspect of the apparel business. It is important to understand that the demand for fashion apparel is seasonal - affected by current fashion, variations in the seasons, festivals and hence difficult to estimate. An apparel retailer could go off target - either by overestimating or underestimating the demand, with overestimating being prevalent. The ordering-manufacturing-stocking cycle is easily a 6-month cycle before the selling actually starts; with an expectation to improve sales year on year, the procurement team buys more, making an increase in the variety of colors and styles to offer more to the consumer. However, not all styles sell as expected, leaving higher than expected stocked inventory, which requires an impetus to sell. The impetus in the industry comes in the form of ''end of season sale (EOSS)''. Decision on the percentage of markdown for EOSS is one of the most critical tasks for an apparel retailer. This activity starts months ahead of the EOSS. The product team and the planning team sit together and come up with an EOSS plan at the style level. In the decision process, procurement and planning team use their domain expertise and judge the performance of style using metrics such as rate of sales, full price sell-through, inventory left, and more. The key decision is to quantify the degree of non-performance of styles that did not sell as forecasted and by how much to markdown for the EOSS.
| Years | Cash Flow | Net Cash Flow | Cumulative Cash Flow |
Discount Rate @ 6 % |
Discounted Cash Flows |
|---|---|---|---|---|---|
| Year 0 | (10025377) | -10025377 | - | - | |
| Year 1 | 3451845 | -6573532 | 3451845 | 0.9434 | 3256458 |
| Year 2 | 3973623 | -2599909 | 7425468 | 0.89 | 3536510 |
| Year 3 | 3958971 | 1359062 | 11384439 | 0.8396 | 3324028 |
| Year 4 | 3229125 | 4588187 | 14613564 | 0.7921 | 2557769 |
| TOTAL | 14613564 | 12674766 |
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. Net Present Value
2. Payback Period
3. Internal Rate of Return
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 Eoss Markdown 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. Eoss Markdown 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 Eoss Markdown 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 Eoss Markdown 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 | (10025377) | -10025377 | - | - | |
| Year 1 | 3451845 | -6573532 | 3451845 | 0.8696 | 3001604 |
| Year 2 | 3973623 | -2599909 | 7425468 | 0.7561 | 3004630 |
| Year 3 | 3958971 | 1359062 | 11384439 | 0.6575 | 2603088 |
| Year 4 | 3229125 | 4588187 | 14613564 | 0.5718 | 1846263 |
| TOTAL | 10455585 |
(10455585 - 10025377 )
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 | (10025377) | -10025377 | - | - | |
| Year 1 | 3451845 | -6573532 | 3451845 | 0.8333 | 2876538 |
| Year 2 | 3973623 | -2599909 | 7425468 | 0.6944 | 2759460 |
| Year 3 | 3958971 | 1359062 | 11384439 | 0.5787 | 2291071 |
| Year 4 | 3229125 | 4588187 | 14613564 | 0.4823 | 1557255 |
| TOTAL | 9484325 |
At 20% discount rate the NPV is negative (9484325 - 10025377 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Eoss Markdown to discount cash flow at lower discount rates such as 15%.
Simplest Approach – If the investment project of Eoss Markdown has a NPV value higher than Zero then finance managers at Eoss Markdown 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 Eoss Markdown, then the stock price of the Eoss Markdown 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 Eoss Markdown 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 –
Understanding of risks involved in the project.
What will be a multi year spillover effect of various taxation regulations.
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.
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.
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.
Deepak George, Karthik Kuram, Ramalakshmi Subramanian, Sumad Singh (2018), "Markdown Optimization for an Indian Apparel Retailer Harvard Business Review Case Study. Published by HBR Publications.
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