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. Why Customer Participation Matters case study is a Harvard Business School (HBR) case study written by Omar Merlo, Andreas B. Eisingerich, Seigyoung Auh. The Why Customer Participation Matters (referred as “Mouth Word” 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.
This is an MIT Sloan Management Review article. Most managers know that listening to customers makes good business sense. Businesses have much to gain from actively seeking and encouraging customer participation, which the authors define as getting customers to provide constructive suggestions and share their ideas on how to shape product and service offerings. Yet many companies only pay lip service to this idea.Rather than encouraging customers to share their views about the company and its products with managers, the authors found, companies tend to focus on encouraging customers to take part in spreading positive word of mouth. Yet word of mouth is only one type of voluntary behavior that customers engage in. Moreover, it indicates only what people on the outside are saying, not how companies can improve their offerings or what customers may be looking for. The authors, who conducted surveys of customers as well as interviews and roundtable discussions with senior executives in a variety of industries, found that both customer word of mouth and customer- to-business interactions are associated with a customer's propensity to buy more of a company's products and services. While not all satisfied customers become repeat buyers, encouraging them to provide feedback and suggestions helps tie them more closely to the business. Companies can even recapture defecting customers simply by contacting them and encouraging them to participate. In addition, customer-to-business interaction is often more malleable than customer-to-customer word of mouth and more readily within the control of management. In a study of customers of a global bank, the authors found that customers who purchased the most were individuals who participated and engaged in much word-of-mouth behavior. High participation/ high word-of-mouth customers were the most loyal and attached to the brand; customers who did not participate tended to be the least valuable, the least loyal and the least attached to the organization regardless of whether they spread positive word of mouth. The implications of the findings are that fostering customer participation can be very valuable and that companies are better off emphasizing customer participation over word of mouth (as opposed to the reverse), because it creates more customer "stickiness"(as in greater attachment and commitment). Nevertheless, the authors say, the two approaches should be seen as two sides of a coin, working both internally and externally to build financial value for companies.
| Years | Cash Flow | Net Cash Flow | Cumulative Cash Flow |
Discount Rate @ 6 % |
Discounted Cash Flows |
|---|---|---|---|---|---|
| Year 0 | (10007681) | -10007681 | - | - | |
| Year 1 | 3454779 | -6552902 | 3454779 | 0.9434 | 3259225 |
| Year 2 | 3958753 | -2594149 | 7413532 | 0.89 | 3523276 |
| Year 3 | 3970403 | 1376254 | 11383935 | 0.8396 | 3333627 |
| Year 4 | 3235997 | 4612251 | 14619932 | 0.7921 | 2563213 |
| TOTAL | 14619932 | 12679341 |
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. Payback Period
2. Profitability Index
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. Mouth Word 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 Mouth Word 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 Mouth Word 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 Mouth Word 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 | (10007681) | -10007681 | - | - | |
| Year 1 | 3454779 | -6552902 | 3454779 | 0.8696 | 3004156 |
| Year 2 | 3958753 | -2594149 | 7413532 | 0.7561 | 2993386 |
| Year 3 | 3970403 | 1376254 | 11383935 | 0.6575 | 2610604 |
| Year 4 | 3235997 | 4612251 | 14619932 | 0.5718 | 1850192 |
| TOTAL | 10458338 |
(10458338 - 10007681 )
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 | (10007681) | -10007681 | - | - | |
| Year 1 | 3454779 | -6552902 | 3454779 | 0.8333 | 2878983 |
| Year 2 | 3958753 | -2594149 | 7413532 | 0.6944 | 2749134 |
| Year 3 | 3970403 | 1376254 | 11383935 | 0.5787 | 2297687 |
| Year 4 | 3235997 | 4612251 | 14619932 | 0.4823 | 1560570 |
| TOTAL | 9486373 |
At 20% discount rate the NPV is negative (9486373 - 10007681 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Mouth Word to discount cash flow at lower discount rates such as 15%.
Simplest Approach – If the investment project of Mouth Word has a NPV value higher than Zero then finance managers at Mouth Word 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 Mouth Word, then the stock price of the Mouth Word 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 Mouth Word 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.
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.
Understanding of risks involved in the project.
What will be a multi year spillover effect of various taxation regulations.
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.
Omar Merlo, Andreas B. Eisingerich, Seigyoung Auh (2018), "Why Customer Participation Matters Harvard Business Review Case Study. Published by HBR Publications.
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