Online Reputation Systems: How to Design One That Does What You Need 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 Online Reputation Systems: How to Design One That Does What You Need case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Online Reputation Systems: How to Design One That Does What You Need case study is a Harvard Business School (HBR) case study written by Chrysanthos Dellarocas. The Online Reputation Systems: How to Design One That Does What You Need (referred as “Reputation Crowds” from here on) case study provides evaluation & decision scenario in field of Sales & Marketing. It also touches upon business topics such as - Value proposition, Product development, 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 Online Reputation Systems: How to Design One That Does What You Need Case Study

This is an MIT Sloan Management Review article. User-generated content platforms, open source software, crowdsourcing and knowledge markets -these are all possible only because of the "social web," the interlinked virtual universe that to so many executives seems to offer the irresistible promise of providing something -ideas, work, decisions -for (almost) nothing, if only they could manage it right. Managing it right means understanding that even though the new platforms are all about harnessing crowds and communities, in the end those crowds and communities are nothing but a sum of individuals. And your company's social web efforts will succeed only to the extent that you are able to attract good individuals, motivate them to perform good work, and empower them to get to know and trust one another enough to collaborate toward the end goals of the community. The question is, How do you do that? The answer: by capitalizing on the motivational power of in reputation -that is, by designing and building an online reputation system that triggers and nourishes the kind of web community that will serve your company's needs. Using examples such as Amazon, eBay, Epinions and Yelp, the author describes how design choices of a reputation system can profoundly affect a community's culture, making an otherwise collaborative and cordial community into a competitive and even combative space.

Case Authors : Chrysanthos Dellarocas

Topic : Sales & Marketing

Related Areas : Product development, Supply chain

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Calculating Net Present Value (NPV) at 6% for Online Reputation Systems: How to Design One That Does What You Need Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10007286)	-10007286	-	-
Year 1	3460285	-6547001	3460285	0.9434	3264420
Year 2	3961458	-2585543	7421743	0.89	3525684
Year 3	3960799	1375256	11382542	0.8396	3325563
Year 4	3247198	4622454	14629740	0.7921	2572085
TOTAL			14629740		12687752

The Net Present Value at 6% discount rate is 2680466

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. Internal Rate of Return
2. Payback Period
3. Net Present Value
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. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Reputation Crowds 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 Reputation Crowds 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 Online Reputation Systems: How to Design One That Does What You Need

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 Reputation Crowds 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 Reputation Crowds 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	(10007286)	-10007286	-	-
Year 1	3460285	-6547001	3460285	0.8696	3008943
Year 2	3961458	-2585543	7421743	0.7561	2995431
Year 3	3960799	1375256	11382542	0.6575	2604290
Year 4	3247198	4622454	14629740	0.5718	1856596
TOTAL					10465260

The Net NPV after 4 years is 457974

(10465260 - 10007286 )

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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	(10007286)	-10007286	-	-
Year 1	3460285	-6547001	3460285	0.8333	2883571
Year 2	3961458	-2585543	7421743	0.6944	2751013
Year 3	3960799	1375256	11382542	0.5787	2292129
Year 4	3247198	4622454	14629740	0.4823	1565971
TOTAL					9492684

The Net NPV after 4 years is -514602

At 20% discount rate the NPV is negative (9492684 - 10007286 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Reputation Crowds 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 Reputation Crowds has a NPV value higher than Zero then finance managers at Reputation Crowds 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 Reputation Crowds, then the stock price of the Reputation Crowds 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 Reputation Crowds 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 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 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.

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 Online Reputation Systems: How to Design One That Does What You Need

References & Further Readings

Chrysanthos Dellarocas (2018), "Online Reputation Systems: How to Design One That Does What You Need Harvard Business Review Case Study. Published by HBR Publications.