Farmacias Ahumada S.A. and the Fundacion Las Rosas, Spanish Version 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 Farmacias Ahumada S.A. and the Fundacion Las Rosas, Spanish Version case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Farmacias Ahumada S.A. and the Fundacion Las Rosas, Spanish Version case study is a Harvard Business School (HBR) case study written by Mladen Koljatic, Monica Silva. The Farmacias Ahumada S.A. and the Fundacion Las Rosas, Spanish Version (referred as “Flr Fasa” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, Joint ventures, Social enterprise.

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 Farmacias Ahumada S.A. and the Fundacion Las Rosas, Spanish Version Case Study

Describes the alliance between Farmacias Ahumada S.A. (FASA), the largest drugstore chain in Chile, and the Las Rosas Foundation (Fundacion Las Rosas, or FLR), a nonprofit organization that provides shelter and care to needy elders. The collaboration began in 1997. The board at FASA opted to partner with a NGO to enhance its public image as a good community neighbor. FASA trained its salespeople to ask drugstore customers for a small monetary contribution at store cash registers to benefit FLR. By 2002, fundraising among FASA customers amounted to $381,000, covering approximately 5% of FLR's operating expenses. One half of store purchases resulted in a small donation for FLR. In recent years, FLR underwent remarkable growth. However, this growth called for an increase in financial resources if the institution were to fulfill its mission appropriately. The nonprofit was offered the chance to enter into a new partnership with an international supermarket chain. A new alliance posed a potential risk to the relationship with FASA, and the foundation's vice-president faced a critical decision. The visibility of a new partnership between FLR and the supermarket might make FLR a less attractive partner for the drugstore chain. Addresses issues of alliance development, strategy valuation, and selection of cross-sector collaborations.

Case Authors : Mladen Koljatic, Monica Silva

Topic : Strategy & Execution

Related Areas : Joint ventures, Social enterprise

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Calculating Net Present Value (NPV) at 6% for Farmacias Ahumada S.A. and the Fundacion Las Rosas, Spanish Version Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10028360)	-10028360	-	-
Year 1	3466980	-6561380	3466980	0.9434	3270736
Year 2	3968614	-2592766	7435594	0.89	3532052
Year 3	3939967	1347201	11375561	0.8396	3308072
Year 4	3250263	4597464	14625824	0.7921	2574513
TOTAL			14625824		12685373

The Net Present Value at 6% discount rate is 2657013

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. Internal Rate of Return
2. Profitability Index
3. Net Present Value
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 Flr Fasa 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. Flr Fasa 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 Farmacias Ahumada S.A. and the Fundacion Las Rosas, Spanish Version

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 Flr Fasa 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 Flr Fasa 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	(10028360)	-10028360	-	-
Year 1	3466980	-6561380	3466980	0.8696	3014765
Year 2	3968614	-2592766	7435594	0.7561	3000842
Year 3	3939967	1347201	11375561	0.6575	2590592
Year 4	3250263	4597464	14625824	0.5718	1858348
TOTAL					10464548

The Net NPV after 4 years is 436188

(10464548 - 10028360 )

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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	(10028360)	-10028360	-	-
Year 1	3466980	-6561380	3466980	0.8333	2889150
Year 2	3968614	-2592766	7435594	0.6944	2755982
Year 3	3939967	1347201	11375561	0.5787	2280073
Year 4	3250263	4597464	14625824	0.4823	1567449
TOTAL					9492655

The Net NPV after 4 years is -535705

At 20% discount rate the NPV is negative (9492655 - 10028360 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Flr Fasa 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 Flr Fasa has a NPV value higher than Zero then finance managers at Flr Fasa 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 Flr Fasa, then the stock price of the Flr Fasa 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 Flr Fasa 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.

Understanding of risks involved in the project.

What can impact the cash flow of 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.

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Negotiation Strategy of Farmacias Ahumada S.A. and the Fundacion Las Rosas, Spanish Version

References & Further Readings

Mladen Koljatic, Monica Silva (2018), "Farmacias Ahumada S.A. and the Fundacion Las Rosas, Spanish Version Harvard Business Review Case Study. Published by HBR Publications.