What People Want (and How to Predict It) 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 What People Want (and How to Predict It) case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. What People Want (and How to Predict It) case study is a Harvard Business School (HBR) case study written by Thomas H. Davenport, Jeanne G. Harris. The What People Want (and How to Predict It) (referred as “Prediction Cultural” from here on) case study provides evaluation & decision scenario in field of Sales & Marketing. It also touches upon business topics such as - Value proposition, Innovation, IT, Marketing.

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 What People Want (and How to Predict It) Case Study

This is an MIT Sloan Management Review article. Historically, neither the creators nor the distributors of cultural products such as books or movies have used analytics -- data, statistics, predictive modeling -- to determine the likely success of their offerings. Instead, companies relied on the brilliance of tastemakers to predict and shape what people would buy. Creative judgment and expertise will always play a vital role in the creation, shaping and marketing of cultural products. But the balance between art and science is shifting. Today companies have unprecedented access to data and sophisticated technology that allows even the best-known experts to weigh factors and consider evidence that was unobtainable just a few years ago. And with increased cost and risk associated with the creation of cultural products, it has never been more important to get these decisions right. In this article, the authors describe the results of a study of prediction and recommendation efforts for a variety of cultural products. They discuss different approaches used to make predictions, the contexts in which these predictions are applied and the barriers to more extensive use, including the problem of decision making pre-creation. They then discuss two aspects of the prediction market. First, the need for better prediction for distributors of cultural products, and second, the potential for business models around prediction techniques.

Case Authors : Thomas H. Davenport, Jeanne G. Harris

Topic : Sales & Marketing

Related Areas : Innovation, IT, Marketing

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Calculating Net Present Value (NPV) at 6% for What People Want (and How to Predict It) Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10015981)	-10015981	-	-
Year 1	3454366	-6561615	3454366	0.9434	3258836
Year 2	3977230	-2584385	7431596	0.89	3539721
Year 3	3951323	1366938	11382919	0.8396	3317607
Year 4	3246941	4613879	14629860	0.7921	2571881
TOTAL			14629860		12688045

The Net Present Value at 6% discount rate is 2672064

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. Payback Period
3. Internal Rate of Return
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. Prediction Cultural 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 Prediction Cultural 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 What People Want (and How to Predict It)

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 Prediction Cultural 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 Prediction Cultural 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	(10015981)	-10015981	-	-
Year 1	3454366	-6561615	3454366	0.8696	3003797
Year 2	3977230	-2584385	7431596	0.7561	3007357
Year 3	3951323	1366938	11382919	0.6575	2598059
Year 4	3246941	4613879	14629860	0.5718	1856449
TOTAL					10465662

The Net NPV after 4 years is 449681

(10465662 - 10015981 )

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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	(10015981)	-10015981	-	-
Year 1	3454366	-6561615	3454366	0.8333	2878638
Year 2	3977230	-2584385	7431596	0.6944	2761965
Year 3	3951323	1366938	11382919	0.5787	2286645
Year 4	3246941	4613879	14629860	0.4823	1565847
TOTAL					9493096

The Net NPV after 4 years is -522885

At 20% discount rate the NPV is negative (9493096 - 10015981 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Prediction Cultural 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 Prediction Cultural has a NPV value higher than Zero then finance managers at Prediction Cultural 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 Prediction Cultural, then the stock price of the Prediction Cultural 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 Prediction Cultural 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 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.

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.

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 What People Want (and How to Predict It)

References & Further Readings

Thomas H. Davenport, Jeanne G. Harris (2018), "What People Want (and How to Predict It) Harvard Business Review Case Study. Published by HBR Publications.