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Update: The Music Industry in 2006 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 Update: The Music Industry in 2006 case study


At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Update: The Music Industry in 2006 case study is a Harvard Business School (HBR) case study written by John R. Wells, Elizabeth A. Raabe. The Update: The Music Industry in 2006 (referred as “Music Bmg” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, .

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






Case Description of Update: The Music Industry in 2006 Case Study


The global recorded music industry was undergoing a major transition in 2006. Sales had been declining for a decade, and consumers were buying music in new formats and through different distribution channels. CD sales still accounted for the majority of revenues, but sales of music in digital formats (downloads, videos, ringtones) were growing significantly and accounting for approximately 10% of the industry's revenues in 2006. Many considered digital the future of the music business but the format posed both opportunities and challenges. While it had revitalized the singles market, for instance, digital had also facilitated rampant piracy. The music industry was retaliating, launching lawsuits against illegitimate peer-to-peer operators such as groups caught downloading illegally. Whether this would be enough to stop the trend was a matter of much debate. Meanwhile, the industry continued to consolidate. In 2004, Sony Music and BMG, the third- and fifth-largest record firms at the time, merged to form Sony BMG. Surprisingly, in 2006 the European Union's Court of First Instance anYou can order --casename-- analysis and solution here ed the merger--which the European Commission had approved two years earlier--after a group of independent music labels complained about the merger's effect on competition. While Sony and BMG were defending the merger in court, EMI Group plc wondered if its desired takeover of Warner Music Group--which it had been pursuing since 2000--would ever happen. If it did, how much business would the new entity have in the rapidly changing environment? All wondered how the industry would evolve.


Case Authors : John R. Wells, Elizabeth A. Raabe

Topic : Strategy & Execution

Related Areas :




Calculating Net Present Value (NPV) at 6% for Update: The Music Industry in 2006 Case Study


Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Discounted
Cash Flows
Year 0 (10013742) -10013742 - -
Year 1 3458338 -6555404 3458338 0.9434 3262583
Year 2 3957519 -2597885 7415857 0.89 3522178
Year 3 3966386 1368501 11382243 0.8396 3330254
Year 4 3242010 4610511 14624253 0.7921 2567976
TOTAL 14624253 12682991




The Net Present Value at 6% discount rate is 2669249

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.




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. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Music Bmg 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 Music Bmg have higher preference for cash returns over 4-5 years rather than 10-15 years given the nature of the volatility in the industry.






Formula and Steps to Calculate Net Present Value (NPV) of Update: The Music Industry in 2006

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 Music Bmg 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 Music Bmg 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 (10013742) -10013742 - -
Year 1 3458338 -6555404 3458338 0.8696 3007250
Year 2 3957519 -2597885 7415857 0.7561 2992453
Year 3 3966386 1368501 11382243 0.6575 2607963
Year 4 3242010 4610511 14624253 0.5718 1853630
TOTAL 10461296


The Net NPV after 4 years is 447554

(10461296 - 10013742 )








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 (10013742) -10013742 - -
Year 1 3458338 -6555404 3458338 0.8333 2881948
Year 2 3957519 -2597885 7415857 0.6944 2748277
Year 3 3966386 1368501 11382243 0.5787 2295362
Year 4 3242010 4610511 14624253 0.4823 1563469
TOTAL 9489057


The Net NPV after 4 years is -524685

At 20% discount rate the NPV is negative (9489057 - 10013742 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Music Bmg 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 Music Bmg has a NPV value higher than Zero then finance managers at Music Bmg 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 Music Bmg, then the stock price of the Music Bmg 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 Music Bmg 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 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.

Understanding of risks involved in 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.






Negotiation Strategy of Update: The Music Industry in 2006

References & Further Readings

John R. Wells, Elizabeth A. Raabe (2018), "Update: The Music Industry in 2006 Harvard Business Review Case Study. Published by HBR Publications.


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