AMG, Inc. & Forsythe Solutions: Lease vs. Buy Decisions 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 AMG, Inc. & Forsythe Solutions: Lease vs. Buy Decisions case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. AMG, Inc. & Forsythe Solutions: Lease vs. Buy Decisions case study is a Harvard Business School (HBR) case study written by Mark Jeffery, H. Nevin Ekici, Cassidy Shield, Mike Conley. The AMG, Inc. & Forsythe Solutions: Lease vs. Buy Decisions (referred as “Lease Leasing” from here on) case study provides evaluation & decision scenario in field of Finance & Accounting. It also touches upon business topics such as - Value proposition, Financial management, IT, Operations management.

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 AMG, Inc. & Forsythe Solutions: Lease vs. Buy Decisions Case Study

Examines the lease vs. buy decision for investments in technology. Addresses pivotal investment decision issues such as varying the length of the lease, the useful life of the equipment, and alignment with the company's overall financial strategy. The scenario is for a real financial services firm that has been disguised for confidentiality reasons. Presents an investment decision: should a company buy or lease technology with a relatively short useful life? The new controller at AMG, a Fortune 500 financial services firm, has been tasked with determining how to finance the acquisition of 7,542 new PCs to be rolled out over the next 12 months. This is a $6.7 million investment decision and the rollout schedule adds significant complexity to the solution. The controller must choose between buying or leasing the computers over 24- or 36-month time frames. Provides a framework for analyzing similar investment decisions. The key learning point is that leasing information technology can be cheaper than buying. This is contradictory to a car lease, which may be familiar from everyday experience. A new car has a potentially long useful life and can retain significant value after several years, hence, intuition is that buying should always be cheaper than leasing. Shows that this is not the case for information technology. Teaches the correct application of the mid-quarter convention within MACRS depreciation for technology, and the implications of operating vs. capital leases and off-balance-sheet financing. In the process, introduces the four tests for a capital lease. Finally, shows how creative analysis techniques can be used to simplify complex decisions. These techniques aid in arriving at a conclusion faster and with less effort.

Case Authors : Mark Jeffery, H. Nevin Ekici, Cassidy Shield, Mike Conley

Topic : Finance & Accounting

Related Areas : Financial management, IT, Operations management

Calculating Net Present Value (NPV) at 6% for AMG, Inc. & Forsythe Solutions: Lease vs. Buy Decisions Case Study

Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Cash Flows
Year 0 (10003844) -10003844 - -
Year 1 3452061 -6551783 3452061 0.9434 3256661
Year 2 3956947 -2594836 7409008 0.89 3521669
Year 3 3951003 1356167 11360011 0.8396 3317338
Year 4 3236782 4592949 14596793 0.7921 2563835
TOTAL 14596793 12659503

The Net Present Value at 6% discount rate is 2655659

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

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. Lease Leasing 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 Lease Leasing have higher preference for cash returns over 4-5 years rather than 10-15 years given the nature of the volatility in the industry.

Formula and Steps to Calculate Net Present Value (NPV) of AMG, Inc. & Forsythe Solutions: Lease vs. Buy Decisions

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 Finance & Accounting 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 Lease Leasing 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 Lease Leasing 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 %
Cash Flows
Year 0 (10003844) -10003844 - -
Year 1 3452061 -6551783 3452061 0.8696 3001792
Year 2 3956947 -2594836 7409008 0.7561 2992020
Year 3 3951003 1356167 11360011 0.6575 2597849
Year 4 3236782 4592949 14596793 0.5718 1850641
TOTAL 10442302

The Net NPV after 4 years is 438458

(10442302 - 10003844 )

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 %
Cash Flows
Year 0 (10003844) -10003844 - -
Year 1 3452061 -6551783 3452061 0.8333 2876718
Year 2 3956947 -2594836 7409008 0.6944 2747880
Year 3 3951003 1356167 11360011 0.5787 2286460
Year 4 3236782 4592949 14596793 0.4823 1560948
TOTAL 9472006

The Net NPV after 4 years is -531838

At 20% discount rate the NPV is negative (9472006 - 10003844 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Lease Leasing 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 Lease Leasing has a NPV value higher than Zero then finance managers at Lease Leasing 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 Lease Leasing, then the stock price of the Lease Leasing 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 Lease Leasing 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.

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.

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.

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.

References & Further Readings

Mark Jeffery, H. Nevin Ekici, Cassidy Shield, Mike Conley (2018), "AMG, Inc. & Forsythe Solutions: Lease vs. Buy Decisions Harvard Business Review Case Study. Published by HBR Publications.