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How to Identify the Best Customers for Your Business 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 How to Identify the Best Customers for Your Business case study


At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. How to Identify the Best Customers for Your Business case study is a Harvard Business School (HBR) case study written by Frank V. Cespedes, James P. Dougherty, Ben S. Skinner III. The How to Identify the Best Customers for Your Business (referred as “Sg Customers” 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.

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






Case Description of How to Identify the Best Customers for Your Business Case Study


This is an MIT Sloan Management Review article. It's difficult to start a venture that gains traction with paying customers, but it's even harder to grow beyond certain levels of sales. Why? The authors point out that, as ventures grow, their complexity increases. Not only are there more "moving parts,"but interdependencies are more difficult to manage. The original business model must deal with new products or markets. Early leadership behaviors that worked in establishing the business are often not adequate to manage and grow it. SG&A (selling, general and administrative) costs often accelerate faster than revenues. The result: Each year thousands of promising ventures are either forced to go out of business or operate in small niches because they are unable to scale their sales activities. The authors illustrate with the example of a real company in the payroll services business. After a period of rapid growth, "BusinessProcessingCo."saw its revenue growth stall and the SG&A burden become untenable. The company had a costly ad hoc process for evaluating opportunities, forecasting and business development initiatives. The leadership team was unable to define its core customers. As the authors explain, different customers come with different transaction costs for the seller. This affects "upstream"capacity utilization in two respects: the product mix of the selling company (what kind of capacity is utilized) and how capacity is utilized (for example, production lines in manufacturing and the types of people and skills in a service business). The selection of customers also affects "downstream"after-sale economics and organizational requirements. The article discusses the importance of customer selection and how intelligent opportunity management can help companies scale their selling initiatives. It concludes with a general framework for helping executives analyze sales productivity and pipeline value.


Case Authors : Frank V. Cespedes, James P. Dougherty, Ben S. Skinner III

Topic : Sales & Marketing

Related Areas : Marketing




Calculating Net Present Value (NPV) at 6% for How to Identify the Best Customers for Your Business Case Study


Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Discounted
Cash Flows
Year 0 (10024688) -10024688 - -
Year 1 3472103 -6552585 3472103 0.9434 3275569
Year 2 3957084 -2595501 7429187 0.89 3521791
Year 3 3937883 1342382 11367070 0.8396 3306323
Year 4 3249744 4592126 14616814 0.7921 2574102
TOTAL 14616814 12677784




The Net Present Value at 6% discount rate is 2653096

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.




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. Net Present Value
3. Payback Period
4. Internal Rate of Return

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 Sg Customers 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. Sg Customers shareholders have preference for diversified projects investment rather than prospective high income from a single capital intensive project.






Formula and Steps to Calculate Net Present Value (NPV) of How to Identify the Best Customers for Your Business

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 Sg Customers 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 Sg Customers 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 (10024688) -10024688 - -
Year 1 3472103 -6552585 3472103 0.8696 3019220
Year 2 3957084 -2595501 7429187 0.7561 2992124
Year 3 3937883 1342382 11367070 0.6575 2589222
Year 4 3249744 4592126 14616814 0.5718 1858052
TOTAL 10458618


The Net NPV after 4 years is 433930

(10458618 - 10024688 )








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 (10024688) -10024688 - -
Year 1 3472103 -6552585 3472103 0.8333 2893419
Year 2 3957084 -2595501 7429187 0.6944 2747975
Year 3 3937883 1342382 11367070 0.5787 2278867
Year 4 3249744 4592126 14616814 0.4823 1567199
TOTAL 9487461


The Net NPV after 4 years is -537227

At 20% discount rate the NPV is negative (9487461 - 10024688 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Sg Customers 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 Sg Customers has a NPV value higher than Zero then finance managers at Sg Customers 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 Sg Customers, then the stock price of the Sg Customers 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 Sg Customers 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 can impact the cash flow of 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 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 will be a multi year spillover effect of various taxation regulations.

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.






Negotiation Strategy of How to Identify the Best Customers for Your Business

References & Further Readings

Frank V. Cespedes, James P. Dougherty, Ben S. Skinner III (2018), "How to Identify the Best Customers for Your Business Harvard Business Review Case Study. Published by HBR Publications.


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