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 Is My Sales Force Automation System Failing? case study is a Harvard Business School (HBR) case study written by Robert M. Barker, Stephan F. Gohmann, Jian Guan, David J. Faulds. The Why Is My Sales Force Automation System Failing? (referred as “Sfa Sales” from here on) case study provides evaluation & decision scenario in field of Sales & Marketing. It also touches upon business topics such as - Value proposition, Sales, Technology.
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.
Sales force automation (SFA) is the use of software to automate sales tasks, including sales activities, order processing, customer management, sales forecasting and analysis, sales force management, and information sharing. An SFA system is often part of an enterprise-wide information system that connects and integrates sales activities with the organization's other operations. Therefore, SFA software is not only a tool critical to the success of today's sales force, but is also vital to the entire organization. SFA has the potential to empower companies to more efficiently manage their sales force and sales processes, to automate and standardize sales activities, and to connect the sales force with the rest of the organization. The value of these potential benefits in terms of lower costs or increased revenues has encouraged businesses to adopt SFA. Once adopted, however, SFA systems often fail to deliver anticipated benefits. The leading cause of SFA failures has been revealed as low user acceptance, which can be attributed to such factors as the disruption of established sales routines, sales force perception of the system as a micromanagement tool, differences in sales force and managerial expectations for the system, and lack of managerial support for the system as perceived by the sales force. Given these circumstances, managers who are aware of the major issues surrounding user acceptance of SFA will be more successful in implementing such systems. This article explores the utilization of SFA, the benefits derived from these systems, and user acceptance issues. Herein, we offer suggestions that will help organizations succeed in adopting SFA systems.
| Years | Cash Flow | Net Cash Flow | Cumulative Cash Flow |
Discount Rate @ 6 % |
Discounted Cash Flows |
|---|---|---|---|---|---|
| Year 0 | (10006738) | -10006738 | - | - | |
| Year 1 | 3456635 | -6550103 | 3456635 | 0.9434 | 3260976 |
| Year 2 | 3957882 | -2592221 | 7414517 | 0.89 | 3522501 |
| Year 3 | 3944199 | 1351978 | 11358716 | 0.8396 | 3311626 |
| Year 4 | 3240514 | 4592492 | 14599230 | 0.7921 | 2566791 |
| TOTAL | 14599230 | 12661893 |
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. 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. Timing of the expected cash flows – stockholders of Sfa Sales 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. Sfa Sales 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 Sfa Sales 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 Sfa Sales 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 | (10006738) | -10006738 | - | - | |
| Year 1 | 3456635 | -6550103 | 3456635 | 0.8696 | 3005770 |
| Year 2 | 3957882 | -2592221 | 7414517 | 0.7561 | 2992727 |
| Year 3 | 3944199 | 1351978 | 11358716 | 0.6575 | 2593375 |
| Year 4 | 3240514 | 4592492 | 14599230 | 0.5718 | 1852774 |
| TOTAL | 10444646 |
(10444646 - 10006738 )
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 | (10006738) | -10006738 | - | - | |
| Year 1 | 3456635 | -6550103 | 3456635 | 0.8333 | 2880529 |
| Year 2 | 3957882 | -2592221 | 7414517 | 0.6944 | 2748529 |
| Year 3 | 3944199 | 1351978 | 11358716 | 0.5787 | 2282523 |
| Year 4 | 3240514 | 4592492 | 14599230 | 0.4823 | 1562748 |
| TOTAL | 9474329 |
At 20% discount rate the NPV is negative (9474329 - 10006738 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Sfa Sales to discount cash flow at lower discount rates such as 15%.
Simplest Approach – If the investment project of Sfa Sales has a NPV value higher than Zero then finance managers at Sfa Sales 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 Sfa Sales, then the stock price of the Sfa Sales 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 Sfa Sales 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.
Understanding of risks involved in 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 will be a multi year spillover effect of various taxation regulations.
What are the key aspects of the projects that need to be monitored, refined, and retuned for continuous delivery of projected cash flows.
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.
Robert M. Barker, Stephan F. Gohmann, Jian Guan, David J. Faulds (2018), "Why Is My Sales Force Automation System Failing? Harvard Business Review Case Study. Published by HBR Publications.
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