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. The Problem With Online Ratings case study is a Harvard Business School (HBR) case study written by Sinan Aral. The The Problem With Online Ratings (referred as “Ratings Comments” 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. In the digital age, we are inundated with other people's opinions. We browse books on Amazon with awareness of how other customers liked (or disliked) a particular tome. On Expedia, we compare hotels based on user ratings. On YouTube, we can check out a video's thumbs-up/thumbs-down score to help determine if it's worth our time.For the most part, consumers have faith in online ratings and view them as trustworthy. But, the author argues, this trust may be misplaced. The heart of the problem lies with our herd instincts -natural human impulses characterized by a lack of individual decision making -that cause us to think and act in the same way as other people around us. When it comes to online ratings, our herd instincts combine with our susceptibility to positive "social influence."When we see that other people have appreciated a certain book, enjoyed a hotel or restaurant or liked a particular doctor, this can cause us to feel the same positive feelings and to provide a similarly high online rating. The author describes an experiment that he and two colleagues conducted on a social news-aggregation website. On the site, users rate news articles and comments by voting them up or down based on how much they enjoyed them. The researchers randomly manipulated the scores of comments with a single up or down vote and then measured the impact of these small manipulations on subsequent scores. The results were striking. The positive manipulations created a positive social influence bias that persisted over five months and that ultimately increased the comments'final ratings by 25%. Negatively manipulated scores, meanwhile, were offset by a correction effect that neutralized the manipulation: Although viewers of negatively manipulated comments were more likely to vote negative (evidence of negative herding), they were even more likely to positively "correct"what they saw as an undeserved negative score. This social-influence bias snowballs into disproportionately high scores, creating a tendency toward positive ratings bubbles. Positively manipulated scores were 30% more likely than control comments (the comments that the researchers did not manipulate) to reach or exceed a score of 10. A positive vote didn't just affect the mean of the ratings distribution; it pushed the upper tail of the distribution out as well, meaning a single positive vote at the beginning could propel comments to ratings stardom.
| Years | Cash Flow | Net Cash Flow | Cumulative Cash Flow |
Discount Rate @ 6 % |
Discounted Cash Flows |
|---|---|---|---|---|---|
| Year 0 | (10026911) | -10026911 | - | - | |
| Year 1 | 3470054 | -6556857 | 3470054 | 0.9434 | 3273636 |
| Year 2 | 3975336 | -2581521 | 7445390 | 0.89 | 3538035 |
| Year 3 | 3940475 | 1358954 | 11385865 | 0.8396 | 3308499 |
| Year 4 | 3236558 | 4595512 | 14622423 | 0.7921 | 2563657 |
| TOTAL | 14622423 | 12683827 |
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. Net Present Value
2. Profitability Index
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 Ratings Comments 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. Ratings Comments shareholders have preference for diversified projects investment rather than prospective high income from a single capital intensive project.
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 Ratings Comments 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 Ratings Comments 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 | (10026911) | -10026911 | - | - | |
| Year 1 | 3470054 | -6556857 | 3470054 | 0.8696 | 3017438 |
| Year 2 | 3975336 | -2581521 | 7445390 | 0.7561 | 3005925 |
| Year 3 | 3940475 | 1358954 | 11385865 | 0.6575 | 2590926 |
| Year 4 | 3236558 | 4595512 | 14622423 | 0.5718 | 1850513 |
| TOTAL | 10464802 |
(10464802 - 10026911 )
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 | (10026911) | -10026911 | - | - | |
| Year 1 | 3470054 | -6556857 | 3470054 | 0.8333 | 2891712 |
| Year 2 | 3975336 | -2581521 | 7445390 | 0.6944 | 2760650 |
| Year 3 | 3940475 | 1358954 | 11385865 | 0.5787 | 2280367 |
| Year 4 | 3236558 | 4595512 | 14622423 | 0.4823 | 1560840 |
| TOTAL | 9493569 |
At 20% discount rate the NPV is negative (9493569 - 10026911 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Ratings Comments to discount cash flow at lower discount rates such as 15%.
Simplest Approach – If the investment project of Ratings Comments has a NPV value higher than Zero then finance managers at Ratings Comments 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 Ratings Comments, then the stock price of the Ratings Comments 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 Ratings Comments 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 uncertainties surrounding the project Initial Cash Outlay (ICO’s). ICO’s often have several different components such as land, machinery, building, and other equipment.
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 will be a multi year spillover effect of various taxation regulations.
What can impact the cash flow of the project.
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.
Sinan Aral (2018), "The Problem With Online Ratings Harvard Business Review Case Study. Published by HBR Publications.
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