Chongqing Peace Medical Corporation Ltd (B): Charting a Strategy in China's Rapidly Changing Health-Care Environment 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 Chongqing Peace Medical Corporation Ltd (B): Charting a Strategy in China's Rapidly Changing Health-Care Environment case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Chongqing Peace Medical Corporation Ltd (B): Charting a Strategy in China's Rapidly Changing Health-Care Environment case study is a Harvard Business School (HBR) case study written by Michael J. Fratantuono, Zhuoran Li. The Chongqing Peace Medical Corporation Ltd (B): Charting a Strategy in China's Rapidly Changing Health-Care Environment (referred as “Peace Medical” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, Leadership, Operations management, Organizational culture.

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 Chongqing Peace Medical Corporation Ltd (B): Charting a Strategy in China's Rapidly Changing Health-Care Environment Case Study

Peace Medical Corporation Ltd ("Peace Medical"), headquartered in Chongqing, China, was founded in 2001 as a joint venture between the very large, state-owned Chongqing Medicine Company ("CMC"), which owns a 51% stake, and Jeff Jiang, the company president, who owns a 49% stake. Both Peace Medical and CMC are medical product supply companies, which are wholesalers that buy pharmaceutical products from manufactures and sell them to hospital-based pharmacies or retail drug stores. From the outset, the arrangement between CMC and Peace Medical has benefited both parties. As of 2008, Peace Medical looks as though it will be a successful company for the long term. It is on a very strong growth trajectory, is financially sound, has accumulated an array of tangible and intangible assets, and has established good relationships with a range of other health-care system participants. Jiang has identified five related objectives for the coming years: first, to strengthen management processes in Peace Medical; second, to intensify sales in the Chongqing area; third, to establish his company's national network and increase sales beyond the Chongqing area; fourth, to become the distributor for several small- to mid-sized foreign businesses hoping to bring their non-generic pharmaceutical products into the China market; and fifth, to explore the possibility of forming a strategic alliance with a company to work in complementary fashion with Peace Medical. The case briefly describes the seven year evolution of Peace Medical. It also describes the role of and pressures facing other types of stakeholders in China's medical products supply chain (manufacturers, hospitals, wholesalers, and so forth). It culminates by asking students to evaluate Jiang's five strategic objectives in light of the core competencies of Peace Medical and to identify possible synergies that might arise from pursuing those objectives.

Case Authors : Michael J. Fratantuono, Zhuoran Li

Topic : Strategy & Execution

Related Areas : Leadership, Operations management, Organizational culture

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Calculating Net Present Value (NPV) at 6% for Chongqing Peace Medical Corporation Ltd (B): Charting a Strategy in China's Rapidly Changing Health-Care Environment Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10001861)	-10001861	-	-
Year 1	3446529	-6555332	3446529	0.9434	3251442
Year 2	3975615	-2579717	7422144	0.89	3538283
Year 3	3946441	1366724	11368585	0.8396	3313508
Year 4	3226289	4593013	14594874	0.7921	2555523
TOTAL			14594874		12658757

The Net Present Value at 6% discount rate is 2656896

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. Profitability Index
3. Internal Rate of Return
4. Payback Period

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 Peace Medical 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. Peace Medical 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 Chongqing Peace Medical Corporation Ltd (B): Charting a Strategy in China's Rapidly Changing Health-Care Environment

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 Peace Medical 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 Peace Medical 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	(10001861)	-10001861	-	-
Year 1	3446529	-6555332	3446529	0.8696	2996982
Year 2	3975615	-2579717	7422144	0.7561	3006136
Year 3	3946441	1366724	11368585	0.6575	2594849
Year 4	3226289	4593013	14594874	0.5718	1844641
TOTAL					10442608

The Net NPV after 4 years is 440747

(10442608 - 10001861 )

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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	(10001861)	-10001861	-	-
Year 1	3446529	-6555332	3446529	0.8333	2872108
Year 2	3975615	-2579717	7422144	0.6944	2760844
Year 3	3946441	1366724	11368585	0.5787	2283820
Year 4	3226289	4593013	14594874	0.4823	1555888
TOTAL					9472659

The Net NPV after 4 years is -529202

At 20% discount rate the NPV is negative (9472659 - 10001861 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Peace Medical 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 Peace Medical has a NPV value higher than Zero then finance managers at Peace Medical 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 Peace Medical, then the stock price of the Peace Medical 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 Peace Medical 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 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.

Understanding of risks involved in the project.

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.

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 Chongqing Peace Medical Corporation Ltd (B): Charting a Strategy in China's Rapidly Changing Health-Care Environment

References & Further Readings

Michael J. Fratantuono, Zhuoran Li (2018), "Chongqing Peace Medical Corporation Ltd (B): Charting a Strategy in China's Rapidly Changing Health-Care Environment Harvard Business Review Case Study. Published by HBR Publications.