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Emerging Markets: Look Before You Leap 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 Emerging Markets: Look Before You Leap case study


At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Emerging Markets: Look Before You Leap case study is a Harvard Business School (HBR) case study written by Tarun Khanna, Krishna G. Palepu. The Emerging Markets: Look Before You Leap (referred as “Emerging Mechanisms” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, Labor, Strategy.

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 Emerging Markets: Look Before You Leap Case Study


Think "emerging markets," and most people think BRICs. The problem with this approach is that it is too simplistic and tends to treat emerging markets as one homogeneous whole, when the exact opposite is true. Instead of asking, "What's my emerging market strategy for Brazil, Russia, India or China?" companies should ask themselves, "In which ways is this particular market emerging?" Viewed this way, the answer may surprise them. The authors synthesize a decade of their research to clear up the confusion that abounds as to whether a market is or isn't emerging. They first explain which institutional mechanisms need to be in place for the healthy functioning of any market, so managers will be able to recognize when these vital mechanisms are absent or deficient. Asking a series of key questions will help managers spot voids, making them better equipped not only to tackle the challenges but to leverage emerging opportunities in all their guises -- whether in the countries that attract the most attention, or in the United States and Western Europe, which may still be "emerging" in some ways.


Case Authors : Tarun Khanna, Krishna G. Palepu

Topic : Strategy & Execution

Related Areas : Labor, Strategy




Calculating Net Present Value (NPV) at 6% for Emerging Markets: Look Before You Leap Case Study


Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Discounted
Cash Flows
Year 0 (10006095) -10006095 - -
Year 1 3447895 -6558200 3447895 0.9434 3252731
Year 2 3955353 -2602847 7403248 0.89 3520250
Year 3 3945378 1342531 11348626 0.8396 3312615
Year 4 3222942 4565473 14571568 0.7921 2552872
TOTAL 14571568 12638469


The Net Present Value at 6% discount rate is 2632374

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. Payback Period
3. Net Present Value
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. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Emerging Mechanisms 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 Emerging Mechanisms 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 Emerging Markets: Look Before You Leap

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 Strategy & Execution 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 Emerging Mechanisms 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 Emerging Mechanisms 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 (10006095) -10006095 - -
Year 1 3447895 -6558200 3447895 0.8696 2998170
Year 2 3955353 -2602847 7403248 0.7561 2990815
Year 3 3945378 1342531 11348626 0.6575 2594150
Year 4 3222942 4565473 14571568 0.5718 1842728
TOTAL 10425862


The Net NPV after 4 years is 419767

(10425862 - 10006095 )






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 (10006095) -10006095 - -
Year 1 3447895 -6558200 3447895 0.8333 2873246
Year 2 3955353 -2602847 7403248 0.6944 2746773
Year 3 3945378 1342531 11348626 0.5787 2283205
Year 4 3222942 4565473 14571568 0.4823 1554274
TOTAL 9457497


The Net NPV after 4 years is -548598

At 20% discount rate the NPV is negative (9457497 - 10006095 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Emerging Mechanisms 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 Emerging Mechanisms has a NPV value higher than Zero then finance managers at Emerging Mechanisms 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 Emerging Mechanisms, then the stock price of the Emerging Mechanisms 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 Emerging Mechanisms 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.

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.

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

Tarun Khanna, Krishna G. Palepu (2018), "Emerging Markets: Look Before You Leap Harvard Business Review Case Study. Published by HBR Publications.