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Market of Exchanges: HKEx and the New Beauty Parade 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 Market of Exchanges: HKEx and the New Beauty Parade case study


At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Market of Exchanges: HKEx and the New Beauty Parade case study is a Harvard Business School (HBR) case study written by Ka-Fu Wong, Jennifer Lee. The Market of Exchanges: HKEx and the New Beauty Parade (referred as “Exchanges Stock” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, Financial markets, Innovation, International business.

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 Market of Exchanges: HKEx and the New Beauty Parade Case Study


Consensus holds that competition between stock exchanges and other types of market participants is beneficial: keep the price of transaction, clearing, and listing services offered low and provide an incentive for product innovation and enhancement. As such, the 1986 unification of stock exchange trading in Hong Kong may seem like a paradoxical development. Prompts an assessment of the benefits of having a single stock exchange in Hong Kong within the broader context of the changing competitive landscape for securities markets.


Case Authors : Ka-Fu Wong, Jennifer Lee

Topic : Strategy & Execution

Related Areas : Financial markets, Innovation, International business




Calculating Net Present Value (NPV) at 6% for Market of Exchanges: HKEx and the New Beauty Parade Case Study


Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Discounted
Cash Flows
Year 0 (10016018) -10016018 - -
Year 1 3451672 -6564346 3451672 0.9434 3256294
Year 2 3963145 -2601201 7414817 0.89 3527185
Year 3 3939681 1338480 11354498 0.8396 3307832
Year 4 3241275 4579755 14595773 0.7921 2567393
TOTAL 14595773 12658705


The Net Present Value at 6% discount rate is 2642687

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. Timing of the expected cash flows – stockholders of Exchanges Stock 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. Exchanges Stock shareholders have preference for diversified projects investment rather than prospective high income from a single capital intensive project.




Formula and Steps to Calculate Net Present Value (NPV) of Market of Exchanges: HKEx and the New Beauty Parade

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 Exchanges Stock 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 Exchanges Stock 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 (10016018) -10016018 - -
Year 1 3451672 -6564346 3451672 0.8696 3001454
Year 2 3963145 -2601201 7414817 0.7561 2996707
Year 3 3939681 1338480 11354498 0.6575 2590404
Year 4 3241275 4579755 14595773 0.5718 1853210
TOTAL 10441775


The Net NPV after 4 years is 425757

(10441775 - 10016018 )






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 (10016018) -10016018 - -
Year 1 3451672 -6564346 3451672 0.8333 2876393
Year 2 3963145 -2601201 7414817 0.6944 2752184
Year 3 3939681 1338480 11354498 0.5787 2279908
Year 4 3241275 4579755 14595773 0.4823 1563115
TOTAL 9471600


The Net NPV after 4 years is -544418

At 20% discount rate the NPV is negative (9471600 - 10016018 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Exchanges Stock 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 Exchanges Stock has a NPV value higher than Zero then finance managers at Exchanges Stock 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 Exchanges Stock, then the stock price of the Exchanges Stock 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 Exchanges Stock 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 will be a multi year spillover effect of various taxation regulations.

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 can impact the cash flow of 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.

Understanding of risks involved in the project.

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

Ka-Fu Wong, Jennifer Lee (2018), "Market of Exchanges: HKEx and the New Beauty Parade Harvard Business Review Case Study. Published by HBR Publications.