LG Chemical: Capacity Expansion and Product Mix in China 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 LG Chemical: Capacity Expansion and Product Mix in China case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. LG Chemical: Capacity Expansion and Product Mix in China case study is a Harvard Business School (HBR) case study written by Bowon Kim, Sanghyung Ahn, Chulsoon Park. The LG Chemical: Capacity Expansion and Product Mix in China (referred as “Lgyx Abs” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, Growth strategy, 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 LG Chemical: Capacity Expansion and Product Mix in China Case Study

LG Chemical had entered into China's market for ABS, a common plastic, through their subsidiary LG Yong Xing ("LGYX"). From its foundation in 1996, LGYX had targeted Chinese manufacturers who served the domestic market and made just one type of low grade ABS. By the end of 2006, LGYX was the largest company in the Chinese ABS market, boasting a 27% market share and sales of US$709 million annually. However, the market for ABS was changing. With exports by Chinese manufacturers growing, demand was shifting to higher grades of ABS. Moreover, LGYX was facing competitive pressure from both local producers as well as producers in the Middle East. Should LGYX stick to its current product mix? Management decided that it must critically review the subsidiary's strategy over the previous ten years in order not to be entrapped in rigid group thinking

Case Authors : Bowon Kim, Sanghyung Ahn, Chulsoon Park

Topic : Strategy & Execution

Related Areas : Growth strategy, International business

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Calculating Net Present Value (NPV) at 6% for LG Chemical: Capacity Expansion and Product Mix in China Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10020522)	-10020522	-	-
Year 1	3463808	-6556714	3463808	0.9434	3267743
Year 2	3979618	-2577096	7443426	0.89	3541846
Year 3	3949920	1372824	11393346	0.8396	3316429
Year 4	3228445	4601269	14621791	0.7921	2557231
TOTAL			14621791		12683249

The Net Present Value at 6% discount rate is 2662727

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 Lgyx Abs 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. Lgyx Abs 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 LG Chemical: Capacity Expansion and Product Mix in China

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 Lgyx Abs 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 Lgyx Abs 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	(10020522)	-10020522	-	-
Year 1	3463808	-6556714	3463808	0.8696	3012007
Year 2	3979618	-2577096	7443426	0.7561	3009163
Year 3	3949920	1372824	11393346	0.6575	2597137
Year 4	3228445	4601269	14621791	0.5718	1845874
TOTAL					10464180

The Net NPV after 4 years is 443658

(10464180 - 10020522 )

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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	(10020522)	-10020522	-	-
Year 1	3463808	-6556714	3463808	0.8333	2886507
Year 2	3979618	-2577096	7443426	0.6944	2763624
Year 3	3949920	1372824	11393346	0.5787	2285833
Year 4	3228445	4601269	14621791	0.4823	1556928
TOTAL					9492891

The Net NPV after 4 years is -527631

At 20% discount rate the NPV is negative (9492891 - 10020522 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Lgyx Abs 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 Lgyx Abs has a NPV value higher than Zero then finance managers at Lgyx Abs 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 Lgyx Abs, then the stock price of the Lgyx Abs 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 Lgyx Abs 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 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.

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 LG Chemical: Capacity Expansion and Product Mix in China

References & Further Readings

Bowon Kim, Sanghyung Ahn, Chulsoon Park (2018), "LG Chemical: Capacity Expansion and Product Mix in China Harvard Business Review Case Study. Published by HBR Publications.