The GSK Scandal: When Questionable Global Practices Met Imperfect Institutions in Emerging Markets 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 The GSK Scandal: When Questionable Global Practices Met Imperfect Institutions in Emerging Markets case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. The GSK Scandal: When Questionable Global Practices Met Imperfect Institutions in Emerging Markets case study is a Harvard Business School (HBR) case study written by Zhigang Tao, W.H. Lo. The The GSK Scandal: When Questionable Global Practices Met Imperfect Institutions in Emerging Markets (referred as “Pharm Gsk” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, Corporate governance, Crisis management, Emerging markets, Ethics, Growth strategy, Performance measurement.

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 The GSK Scandal: When Questionable Global Practices Met Imperfect Institutions in Emerging Markets Case Study

China's healthcare reforms in the 1980s left the country's hospitals under-subsidized and its medical officials underpaid. Hospitals relied on profits generated from the provision of medical services to cover the funding gap, while doctors became kickback seekers to make up for their low rates. In traditional markets, global pharmaceutical companies ("pharm companies") are no strangers to wooing hospitals and doctors to favor prescriptions of their drugs. These questionable "marketing" practices were taken to the next level in the China market. Streams of financial flows, legal or not, from pharm companies to hospitals and doctors to win their favor in prescribing their drugs became a structurally embedded problem of the country's healthcare system. The Chinese government introduced a new round of reform in 2009. While it promises to spend millions more on healthcare, its action to wipe out bribery and other kickback-seeking behaviors of the industry left many players perplexed. The first to take the heat was GlaxoSmithKline Inc. ("GSK"), a large British pharm company active in the China market since 1984. In July 2013, the Chinese government launched an investigation on GSK's China operation regarding its activities that lure hospitals doctors and administers to buy GSK drugs. The alleged practice of bribery is an industry open secret common to pharm companies. Is this investigation an indication that the Chinese government is targeting multinationals in favor of local players? Despite high-voltage growth rates, this regulated industry in the market economy with Chinese characteristics only has a bare-boned distributions infrastructure, while it is filled with patient-trying administrative hurdles, has price restrictions on an expanded list of drugs, and offers weak institutional protection for companies' intellectual property. Will long-term investment in the country pay off? Should GSK continue its China business? Should it change its strategy in China?

Case Authors : Zhigang Tao, W.H. Lo

Topic : Strategy & Execution

Related Areas : Corporate governance, Crisis management, Emerging markets, Ethics, Growth strategy, Performance measurement

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Calculating Net Present Value (NPV) at 6% for The GSK Scandal: When Questionable Global Practices Met Imperfect Institutions in Emerging Markets Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10012196)	-10012196	-	-
Year 1	3449532	-6562664	3449532	0.9434	3254275
Year 2	3955092	-2607572	7404624	0.89	3520018
Year 3	3948750	1341178	11353374	0.8396	3315447
Year 4	3235055	4576233	14588429	0.7921	2562467
TOTAL			14588429		12652206

The Net Present Value at 6% discount rate is 2640010

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. Payback Period
4. Net Present Value

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 Pharm Gsk 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. Pharm Gsk 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 The GSK Scandal: When Questionable Global Practices Met Imperfect Institutions in Emerging Markets

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 Pharm Gsk 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 Pharm Gsk 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	(10012196)	-10012196	-	-
Year 1	3449532	-6562664	3449532	0.8696	2999593
Year 2	3955092	-2607572	7404624	0.7561	2990618
Year 3	3948750	1341178	11353374	0.6575	2596367
Year 4	3235055	4576233	14588429	0.5718	1849653
TOTAL					10436231

The Net NPV after 4 years is 424035

(10436231 - 10012196 )

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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	(10012196)	-10012196	-	-
Year 1	3449532	-6562664	3449532	0.8333	2874610
Year 2	3955092	-2607572	7404624	0.6944	2746592
Year 3	3948750	1341178	11353374	0.5787	2285156
Year 4	3235055	4576233	14588429	0.4823	1560115
TOTAL					9466473

The Net NPV after 4 years is -545723

At 20% discount rate the NPV is negative (9466473 - 10012196 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Pharm Gsk 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 Pharm Gsk has a NPV value higher than Zero then finance managers at Pharm Gsk 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 Pharm Gsk, then the stock price of the Pharm Gsk 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 Pharm Gsk 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 The GSK Scandal: When Questionable Global Practices Met Imperfect Institutions in Emerging Markets

References & Further Readings

Zhigang Tao, W.H. Lo (2018), "The GSK Scandal: When Questionable Global Practices Met Imperfect Institutions in Emerging Markets Harvard Business Review Case Study. Published by HBR Publications.