Lucchetti 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 Lucchetti case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Lucchetti case study is a Harvard Business School (HBR) case study written by U. Srinivasa Rangan, Ed Cale, David Wylie. The Lucchetti (referred as “Lucchetti Peruvian” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, 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

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Case Description of Lucchetti Case Study

Chronicles the experience of Lucchetti, a Quinenco subsidiary, as it expanded from its historically strong domestic stronghold into Peru. Lucchetti, a pasta company, had grown to the point where there was no room to expand in the Chilean market. The Peruvian market, however, looked extremely promising. Thus, in 1996, Lucchetti Peru was born. By late 2003, however, the new state-of-the-art pasta plant was being liquidated. The management of the company was considering whether Lucchetti should leave the Peruvian market altogether and absorb a $150 million write-off or, alternatively, to continue and build a new plant to take advantage of what was left of the Lucchetti market share, despite the considerable additional investment required. Had this been a case of a good strategy plagued by Murphy's Law? Was there something they should have known or some point where the team members had made the wrong decision? The lesson to be gleaned from this failed Peruvian venture remained unclear, but they wanted to apply those lessons to future domestic and international expansion ventures.

Case Authors : U. Srinivasa Rangan, Ed Cale, David Wylie

Topic : Strategy & Execution

Related Areas : International business

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Calculating Net Present Value (NPV) at 6% for Lucchetti Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10026263)	-10026263	-	-
Year 1	3468167	-6558096	3468167	0.9434	3271856
Year 2	3953095	-2605001	7421262	0.89	3518240
Year 3	3937732	1332731	11358994	0.8396	3306196
Year 4	3241005	4573736	14599999	0.7921	2567180
TOTAL			14599999		12663471

The Net Present Value at 6% discount rate is 2637208

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. Net Present Value
2. Internal Rate of Return
3. Payback Period
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 Lucchetti Peruvian 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. Lucchetti Peruvian 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 Lucchetti

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 Lucchetti Peruvian 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 Lucchetti Peruvian 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	(10026263)	-10026263	-	-
Year 1	3468167	-6558096	3468167	0.8696	3015797
Year 2	3953095	-2605001	7421262	0.7561	2989108
Year 3	3937732	1332731	11358994	0.6575	2589123
Year 4	3241005	4573736	14599999	0.5718	1853055
TOTAL					10447083

The Net NPV after 4 years is 420820

(10447083 - 10026263 )

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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	(10026263)	-10026263	-	-
Year 1	3468167	-6558096	3468167	0.8333	2890139
Year 2	3953095	-2605001	7421262	0.6944	2745205
Year 3	3937732	1332731	11358994	0.5787	2278780
Year 4	3241005	4573736	14599999	0.4823	1562985
TOTAL					9477109

The Net NPV after 4 years is -549154

At 20% discount rate the NPV is negative (9477109 - 10026263 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Lucchetti Peruvian 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 Lucchetti Peruvian has a NPV value higher than Zero then finance managers at Lucchetti Peruvian 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 Lucchetti Peruvian, then the stock price of the Lucchetti Peruvian 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 Lucchetti Peruvian 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 –

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.

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.

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 Lucchetti

References & Further Readings

U. Srinivasa Rangan, Ed Cale, David Wylie (2018), "Lucchetti Harvard Business Review Case Study. Published by HBR Publications.