Drug Eluting Stents: A Paradigm Shift in the Medical Device Industry 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 Drug Eluting Stents: A Paradigm Shift in the Medical Device Industry case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Drug Eluting Stents: A Paradigm Shift in the Medical Device Industry case study is a Harvard Business School (HBR) case study written by Stefanos Zenios, Lyn Denend. The Drug Eluting Stents: A Paradigm Shift in the Medical Device Industry (referred as “Dess Des” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, Financial markets.

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 Drug Eluting Stents: A Paradigm Shift in the Medical Device Industry Case Study

By the mid-2000s, no segment of the $180 billion global medical device industry was as dynamic as the market for drug eluting stents (DESs). In the United States, which accounted for nearly three-quarters of the total DES market, only two companies had regulatory approval to sell the small devices: Johnson & Johnson and Boston Scientific. In combination, these two organizations expected 2005 DES sales of approximately $5.5 billion--an increase of 36% from 2004. Forecasts called for the segment to exceed $7 billion by 2008. Driven in part by its size, the DES market was among the most competitive and challenging sectors in the medical device industry. The competitive landscape was marked by intense rivalries and plagued by fierce litigation over intellectual property. Yet, it was also characterized by complex intercompany partnerships, collaboration, and licensing deals. Although DESs had been shown to significantly reduce restenosis rates, new safety concerns were emerging related to the development of life threatening blood clots linked to DESs. Some controversy also existed regarding the cost/benefit of DESs. And product recalls and program failures were common as companies sought to bring new DES technologies to market. Against this backdrop, the segment was characterized by dramatic swings in market share. Despite all of this, the future for DESs looked promising.

Case Authors : Stefanos Zenios, Lyn Denend

Topic : Strategy & Execution

Related Areas : Financial markets

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Calculating Net Present Value (NPV) at 6% for Drug Eluting Stents: A Paradigm Shift in the Medical Device Industry Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10013899)	-10013899	-	-
Year 1	3447966	-6565933	3447966	0.9434	3252798
Year 2	3974557	-2591376	7422523	0.89	3537342
Year 3	3959653	1368277	11382176	0.8396	3324601
Year 4	3241142	4609419	14623318	0.7921	2567288
TOTAL			14623318		12682029

The Net Present Value at 6% discount rate is 2668130

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. Payback Period
2. Net Present Value
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 Dess Des 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. Dess Des 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 Drug Eluting Stents: A Paradigm Shift in the Medical Device Industry

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 Dess Des 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 Dess Des 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	(10013899)	-10013899	-	-
Year 1	3447966	-6565933	3447966	0.8696	2998231
Year 2	3974557	-2591376	7422523	0.7561	3005336
Year 3	3959653	1368277	11382176	0.6575	2603536
Year 4	3241142	4609419	14623318	0.5718	1853133
TOTAL					10460237

The Net NPV after 4 years is 446338

(10460237 - 10013899 )

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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	(10013899)	-10013899	-	-
Year 1	3447966	-6565933	3447966	0.8333	2873305
Year 2	3974557	-2591376	7422523	0.6944	2760109
Year 3	3959653	1368277	11382176	0.5787	2291466
Year 4	3241142	4609419	14623318	0.4823	1563051
TOTAL					9487931

The Net NPV after 4 years is -525968

At 20% discount rate the NPV is negative (9487931 - 10013899 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Dess Des 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 Dess Des has a NPV value higher than Zero then finance managers at Dess Des 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 Dess Des, then the stock price of the Dess Des 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 Dess Des 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 are the key aspects of the projects that need to be monitored, refined, and retuned for continuous delivery of projected cash flows.

What will be a multi year spillover effect of various taxation regulations.

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 Drug Eluting Stents: A Paradigm Shift in the Medical Device Industry

References & Further Readings

Stefanos Zenios, Lyn Denend (2018), "Drug Eluting Stents: A Paradigm Shift in the Medical Device Industry Harvard Business Review Case Study. Published by HBR Publications.