Knights Apparel and the Alta Gracia Factory: Paying a Living Wage 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 Knights Apparel and the Alta Gracia Factory: Paying a Living Wage case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Knights Apparel and the Alta Gracia Factory: Paying a Living Wage case study is a Harvard Business School (HBR) case study written by Paul Brest, Debra Schifrin. The Knights Apparel and the Alta Gracia Factory: Paying a Living Wage (referred as “Knights Gracia” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, Budgeting, Compensation, Emerging markets, Manufacturing, Social responsibility, Supply chain.

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 Knights Apparel and the Alta Gracia Factory: Paying a Living Wage Case Study

In 2014 The Alta Gracia clothing factory in the Dominican Republic was doing something quite unusual in the industry; it was paying its employees a living wage, which was 350 percent higher than the country's minimum wage. Knights Apparel, which owned the four-year old factory, also provided benefits, health care, and allowed the workers to unionize. Most apparel factories paid employees a minimum wage, which in some places was not enough to pay for workers' basic needs and the needs of their families. Knights Apparel founder and CEO Joe Bozich, the driving force behind Alta Gracia, came to this decision from both business and personal motivations. Knights Apparel was the number one provider of licensed collegiate logo apparel, and Bozich saw the opportunity presented by the growing number of college students unhappy with the working conditions of the people making their schools' branded apparel. Personally, Bozich said he wanted to provide "hope and a pathway out of poverty for generations to come." However, Alta Gracia's production costs were 20-30 percent higher than at Knights' other factories, and Alta Gracia was losing over half a million dollars a year. Knights was able to keep Alta Gracia open only by subsidizing it with funds from its profitable business units. Knights was a private company, but Bozich was still accountable to his board and the company's large multi-billion-dollar institutional investors. Over time, Bozich had convinced many of them to back Alta Gracia, but he needed to pull the factory into profitability soon in order to prove it was a viable business model. If Alta Gracia was successful, Knights would have to decide if it should be expanded. There was also the question of whether Knights would be able to replicate Alta Gracia, and if it could, should it? Other companies had tried and failed to offer a living wage and become profitable. Would Knights be different?

Case Authors : Paul Brest, Debra Schifrin

Topic : Strategy & Execution

Related Areas : Budgeting, Compensation, Emerging markets, Manufacturing, Social responsibility, Supply chain

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Calculating Net Present Value (NPV) at 6% for Knights Apparel and the Alta Gracia Factory: Paying a Living Wage Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10000498)	-10000498	-	-
Year 1	3443441	-6557057	3443441	0.9434	3248529
Year 2	3960856	-2596201	7404297	0.89	3525148
Year 3	3936350	1340149	11340647	0.8396	3305035
Year 4	3250973	4591122	14591620	0.7921	2575075
TOTAL			14591620		12653787

The Net Present Value at 6% discount rate is 2653289

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

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 Knights Gracia 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. Knights Gracia 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 Knights Apparel and the Alta Gracia Factory: Paying a Living Wage

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 Knights Gracia 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 Knights Gracia 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	(10000498)	-10000498	-	-
Year 1	3443441	-6557057	3443441	0.8696	2994297
Year 2	3960856	-2596201	7404297	0.7561	2994976
Year 3	3936350	1340149	11340647	0.6575	2588214
Year 4	3250973	4591122	14591620	0.5718	1858754
TOTAL					10436241

The Net NPV after 4 years is 435743

(10436241 - 10000498 )

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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	(10000498)	-10000498	-	-
Year 1	3443441	-6557057	3443441	0.8333	2869534
Year 2	3960856	-2596201	7404297	0.6944	2750594
Year 3	3936350	1340149	11340647	0.5787	2277980
Year 4	3250973	4591122	14591620	0.4823	1567792
TOTAL					9465901

The Net NPV after 4 years is -534597

At 20% discount rate the NPV is negative (9465901 - 10000498 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Knights Gracia 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 Knights Gracia has a NPV value higher than Zero then finance managers at Knights Gracia 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 Knights Gracia, then the stock price of the Knights Gracia 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 Knights Gracia 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.

What are the key aspects of the projects that need to be monitored, refined, and retuned for continuous delivery of projected cash flows.

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 Knights Apparel and the Alta Gracia Factory: Paying a Living Wage

References & Further Readings

Paul Brest, Debra Schifrin (2018), "Knights Apparel and the Alta Gracia Factory: Paying a Living Wage Harvard Business Review Case Study. Published by HBR Publications.