Kmart, Sears, and ESL: How a Hedge Fund Became One of the World's Largest Retailers 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 Kmart, Sears, and ESL: How a Hedge Fund Became One of the World's Largest Retailers case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Kmart, Sears, and ESL: How a Hedge Fund Became One of the World's Largest Retailers case study is a Harvard Business School (HBR) case study written by David P. Stowell, Paul Stowell. The Kmart, Sears, and ESL: How a Hedge Fund Became One of the World's Largest Retailers (referred as “Esl Kmart's” from here on) case study provides evaluation & decision scenario in field of Finance & Accounting. It also touches upon business topics such as - Value proposition, Financial analysis, Financial management, Mergers & acquisitions, Reorganization.

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 Kmart, Sears, and ESL: How a Hedge Fund Became One of the World's Largest Retailers Case Study

Within 18 months of exiting bankruptcy, Kmart's position was sufficiently strong to launch an acquisition of Sears, once the nation's largest retailer and also a core holding of ESL. Looks at a number of compelling issues related to Kmart's bankruptcy, restructuring, and rebirth under the control of ESL, a large hedge fund. Presents some of the key metrics that Eddie Lampert, head of ESL, had available to him as he made two decisions: first, in 2002, to amass a controlling stake in Kmart's defaulted debt during the restructuring; and second, in 2004, to launch a takeover of Sears. The first deal illustrates the decision-making process for a financial buyer, including the downside protection of Kmart's real estate holdings, whereas the second deal represents a traditional strategic acquisition. Illustrates the innovative use of real estate as a "hedge" for ESL in the event that the retail combination does not produce the required financial results. Also focuses on the role of investment bankers and the increasingly important position that hedge funds and LBO funds have carved out in the M&A market.

Case Authors : David P. Stowell, Paul Stowell

Topic : Finance & Accounting

Related Areas : Financial analysis, Financial management, Mergers & acquisitions, Reorganization

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Calculating Net Present Value (NPV) at 6% for Kmart, Sears, and ESL: How a Hedge Fund Became One of the World's Largest Retailers Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10024522)	-10024522	-	-
Year 1	3467768	-6556754	3467768	0.9434	3271479
Year 2	3966634	-2590120	7434402	0.89	3530290
Year 3	3950422	1360302	11384824	0.8396	3316850
Year 4	3234569	4594871	14619393	0.7921	2562082
TOTAL			14619393		12680701

The Net Present Value at 6% discount rate is 2656179

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. Payback Period
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. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Esl Kmart's shareholders have preference for diversified projects investment rather than prospective high income from a single capital intensive project.
2. Timing of the expected cash flows – stockholders of Esl Kmart's have higher preference for cash returns over 4-5 years rather than 10-15 years given the nature of the volatility in the industry.

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Formula and Steps to Calculate Net Present Value (NPV) of Kmart, Sears, and ESL: How a Hedge Fund Became One of the World's Largest Retailers

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 Finance & Accounting 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 Esl Kmart's 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 Esl Kmart's 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	(10024522)	-10024522	-	-
Year 1	3467768	-6556754	3467768	0.8696	3015450
Year 2	3966634	-2590120	7434402	0.7561	2999345
Year 3	3950422	1360302	11384824	0.6575	2597467
Year 4	3234569	4594871	14619393	0.5718	1849375
TOTAL					10461638

The Net NPV after 4 years is 437116

(10461638 - 10024522 )

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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	(10024522)	-10024522	-	-
Year 1	3467768	-6556754	3467768	0.8333	2889807
Year 2	3966634	-2590120	7434402	0.6944	2754607
Year 3	3950422	1360302	11384824	0.5787	2286124
Year 4	3234569	4594871	14619393	0.4823	1559881
TOTAL					9490418

The Net NPV after 4 years is -534104

At 20% discount rate the NPV is negative (9490418 - 10024522 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Esl Kmart's 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 Esl Kmart's has a NPV value higher than Zero then finance managers at Esl Kmart's 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 Esl Kmart's, then the stock price of the Esl Kmart's 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 Esl Kmart's 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 will be a multi year spillover effect of various taxation regulations.

Understanding of risks involved in 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.

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

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 Kmart, Sears, and ESL: How a Hedge Fund Became One of the World's Largest Retailers

References & Further Readings

David P. Stowell, Paul Stowell (2018), "Kmart, Sears, and ESL: How a Hedge Fund Became One of the World's Largest Retailers Harvard Business Review Case Study. Published by HBR Publications.