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Parmalat SpA: An Impressive Milking System 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 Parmalat SpA: An Impressive Milking System case study


At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Parmalat SpA: An Impressive Milking System case study is a Harvard Business School (HBR) case study written by Stewart Hamilton, Ivan Moss. The Parmalat SpA: An Impressive Milking System (referred as “Parmalat's Parmalat” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, Ethics, Reorganization.

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 Parmalat SpA: An Impressive Milking System Case Study


In December 2003, Parmalat SpA collapsed into unexpected bankruptcy. Its off-balance sheet debts were later revealed to total 14.3 billion euros, and it was discovered that it had allegedly been falsifying its accounts and profits for a period of over 10 years. Details the history of the company and Calisto Tanzi, the entrepreneur who founded it. Also describes the development to date of Parmalat's "Extraordinary Administration," the restructuring of the company under the Italian equivalent of Chapter 11 insolvency. Looks at how Parmalat disguised its financial problems for so long. Also explores: (1) when and why Parmalat's financial problems started; (2) how much Parmalat's strategy contributed to its problems; (3) the impact of changing external environments (political and economic) on Parmalat's problems; (4) the effect of Parmalat's history and origins as a family company on the way it managed its problems; (5) how such large accounting mis-statements could be perpetrated; (6) how those mis-statements could go undetected by investors, bankers, and regulators; and (7) what red flags and warning signals could have alerted outsiders to Parmalat's problems.


Case Authors : Stewart Hamilton, Ivan Moss

Topic : Strategy & Execution

Related Areas : Ethics, Reorganization




Calculating Net Present Value (NPV) at 6% for Parmalat SpA: An Impressive Milking System Case Study


Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Discounted
Cash Flows
Year 0 (10020874) -10020874 - -
Year 1 3467740 -6553134 3467740 0.9434 3271453
Year 2 3969642 -2583492 7437382 0.89 3532967
Year 3 3961999 1378507 11399381 0.8396 3326571
Year 4 3228836 4607343 14628217 0.7921 2557541
TOTAL 14628217 12688531




The Net Present Value at 6% discount rate is 2667657

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. Payback Period
2. Net Present Value
3. Internal Rate of Return
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. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Parmalat's Parmalat 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 Parmalat's Parmalat 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 Parmalat SpA: An Impressive Milking System

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 Parmalat's Parmalat 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 Parmalat's Parmalat 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 (10020874) -10020874 - -
Year 1 3467740 -6553134 3467740 0.8696 3015426
Year 2 3969642 -2583492 7437382 0.7561 3001620
Year 3 3961999 1378507 11399381 0.6575 2605079
Year 4 3228836 4607343 14628217 0.5718 1846097
TOTAL 10468222


The Net NPV after 4 years is 447348

(10468222 - 10020874 )








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 (10020874) -10020874 - -
Year 1 3467740 -6553134 3467740 0.8333 2889783
Year 2 3969642 -2583492 7437382 0.6944 2756696
Year 3 3961999 1378507 11399381 0.5787 2292823
Year 4 3228836 4607343 14628217 0.4823 1557116
TOTAL 9496419


The Net NPV after 4 years is -524455

At 20% discount rate the NPV is negative (9496419 - 10020874 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Parmalat's Parmalat 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 Parmalat's Parmalat has a NPV value higher than Zero then finance managers at Parmalat's Parmalat 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 Parmalat's Parmalat, then the stock price of the Parmalat's Parmalat 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 Parmalat's Parmalat 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 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 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.

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.






Negotiation Strategy of Parmalat SpA: An Impressive Milking System

References & Further Readings

Stewart Hamilton, Ivan Moss (2018), "Parmalat SpA: An Impressive Milking System Harvard Business Review Case Study. Published by HBR Publications.


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