Changing Channels: The Impact of the Internet on Distribution Strategy 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 Changing Channels: The Impact of the Internet on Distribution Strategy case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Changing Channels: The Impact of the Internet on Distribution Strategy case study is a Harvard Business School (HBR) case study written by Leyland Pitt, Pierre R. Berthon, Jean-Paul Berthon. The Changing Channels: The Impact of the Internet on Distribution Strategy (referred as “Channels Distribution” 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, Supply chain.

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 Changing Channels: The Impact of the Internet on Distribution Strategy Case Study

A new medium--the Internet and World Wide Web--is changing distribution channels like no other force since the Industrial Revolution. It is modifying many of the assumptions on which channel structure is based, and in some cases it is transforming and even obliterating channels themselves. As a result, many intermediaries will die out, while new channels and intermediaries will take their place. There are three essential purposes of distribution channels: to support economies of scope, to routinize transactions, and to search for information essential to both producer and consumer. However, the Internet and Web have brought about the death of distance, the homogenization of time, and the irrelevance of location. A matrix model of these developments, arrayed versus distribution channel functions, provides a guide to identifying which traditional channels will either undergo transformation or perish and where new channels will emerge. The matrix model suggests how existing firms and entrepreneurs can perform their distribution functions more efficiently. It enables identification of competitors poised to use the media to change the rules of the marketplace. Finally, it helps managers brainstorm ways in which an existing industry can be vulnerable and a totally new one defined.

Case Authors : Leyland Pitt, Pierre R. Berthon, Jean-Paul Berthon

Topic : Sales & Marketing

Related Areas : Marketing, Supply chain

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Calculating Net Present Value (NPV) at 6% for Changing Channels: The Impact of the Internet on Distribution Strategy Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10009281)	-10009281	-	-
Year 1	3470723	-6538558	3470723	0.9434	3274267
Year 2	3965339	-2573219	7436062	0.89	3529138
Year 3	3962295	1389076	11398357	0.8396	3326819
Year 4	3237317	4626393	14635674	0.7921	2564258
TOTAL			14635674		12694482

The Net Present Value at 6% discount rate is 2685201

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. Channels Distribution 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 Channels Distribution 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 Changing Channels: The Impact of the Internet on Distribution Strategy

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 Channels Distribution 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 Channels Distribution 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	(10009281)	-10009281	-	-
Year 1	3470723	-6538558	3470723	0.8696	3018020
Year 2	3965339	-2573219	7436062	0.7561	2998366
Year 3	3962295	1389076	11398357	0.6575	2605273
Year 4	3237317	4626393	14635674	0.5718	1850947
TOTAL					10472606

The Net NPV after 4 years is 463325

(10472606 - 10009281 )

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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	(10009281)	-10009281	-	-
Year 1	3470723	-6538558	3470723	0.8333	2892269
Year 2	3965339	-2573219	7436062	0.6944	2753708
Year 3	3962295	1389076	11398357	0.5787	2292995
Year 4	3237317	4626393	14635674	0.4823	1561206
TOTAL					9500178

The Net NPV after 4 years is -509103

At 20% discount rate the NPV is negative (9500178 - 10009281 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Channels Distribution 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 Channels Distribution has a NPV value higher than Zero then finance managers at Channels Distribution 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 Channels Distribution, then the stock price of the Channels Distribution 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 Channels Distribution 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 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.

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 Changing Channels: The Impact of the Internet on Distribution Strategy

References & Further Readings

Leyland Pitt, Pierre R. Berthon, Jean-Paul Berthon (2018), "Changing Channels: The Impact of the Internet on Distribution Strategy Harvard Business Review Case Study. Published by HBR Publications.