Honda Performance Development: CART vs. IRL--Who Has the Inside Track? 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 Honda Performance Development: CART vs. IRL--Who Has the Inside Track? case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Honda Performance Development: CART vs. IRL--Who Has the Inside Track? case study is a Harvard Business School (HBR) case study written by George Foster, David W. Hoyt, Tom Covington, Jake Moskowitz. The Honda Performance Development: CART vs. IRL--Who Has the Inside Track? (referred as “Irl Racing” from here on) case study provides evaluation & decision scenario in field of Sales & Marketing. It also touches upon business topics such as - Value proposition, Human resource management, 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

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Case Description of Honda Performance Development: CART vs. IRL--Who Has the Inside Track? Case Study

In 2001, Honda supplied engines to the Championship Auto Racing Teams (CART) series, the most technically sophisticated racing series in North America. In 1996, a rival series had broken off from CART--the Indy Racing League (IRL). The owner of the Indianapolis Motor Speedway controlled the IRL, which centered around the Indy 500. Since its founding, the IRL had become well established and threatened CART's future. Honda had many reasons to be unhappy with CART, including uncertainties surrounding future engine specifications. A large part of Honda's motivation for racing was to train its engineers and to compete at the most technically sophisticated level. The IRL's lower tech engines did not offer the technical challenge that Honda sought. However, Honda's most important rival, Toyota, announced that it would move to the IRL, and it appeared that some of the most powerful race teams might also make that move. At the end of the 2001 season, Honda needed to decide on the direction of its auto racing future. Provides an overview of the business of auto racing.

Case Authors : George Foster, David W. Hoyt, Tom Covington, Jake Moskowitz

Topic : Sales & Marketing

Related Areas : Human resource management, Marketing

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Calculating Net Present Value (NPV) at 6% for Honda Performance Development: CART vs. IRL--Who Has the Inside Track? Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10020301)	-10020301	-	-
Year 1	3464398	-6555903	3464398	0.9434	3268300
Year 2	3962752	-2593151	7427150	0.89	3526835
Year 3	3962509	1369358	11389659	0.8396	3326999
Year 4	3251190	4620548	14640849	0.7921	2575247
TOTAL			14640849		12697381

The Net Present Value at 6% discount rate is 2677080

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. Payback Period
2. Internal Rate of Return
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 Irl Racing 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. Irl Racing shareholders have preference for diversified projects investment rather than prospective high income from a single capital intensive project.

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Formula and Steps to Calculate Net Present Value (NPV) of Honda Performance Development: CART vs. IRL--Who Has the Inside Track?

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 Irl Racing 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 Irl Racing 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	(10020301)	-10020301	-	-
Year 1	3464398	-6555903	3464398	0.8696	3012520
Year 2	3962752	-2593151	7427150	0.7561	2996410
Year 3	3962509	1369358	11389659	0.6575	2605414
Year 4	3251190	4620548	14640849	0.5718	1858878
TOTAL					10473222

The Net NPV after 4 years is 452921

(10473222 - 10020301 )

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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	(10020301)	-10020301	-	-
Year 1	3464398	-6555903	3464398	0.8333	2886998
Year 2	3962752	-2593151	7427150	0.6944	2751911
Year 3	3962509	1369358	11389659	0.5787	2293119
Year 4	3251190	4620548	14640849	0.4823	1567896
TOTAL					9499924

The Net NPV after 4 years is -520377

At 20% discount rate the NPV is negative (9499924 - 10020301 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Irl Racing 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 Irl Racing has a NPV value higher than Zero then finance managers at Irl Racing 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 Irl Racing, then the stock price of the Irl Racing 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 Irl Racing 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 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.

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 Honda Performance Development: CART vs. IRL--Who Has the Inside Track?

References & Further Readings

George Foster, David W. Hoyt, Tom Covington, Jake Moskowitz (2018), "Honda Performance Development: CART vs. IRL--Who Has the Inside Track? Harvard Business Review Case Study. Published by HBR Publications.