SOHO China: Design, Development, and Social Harmony 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 SOHO China: Design, Development, and Social Harmony case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. SOHO China: Design, Development, and Social Harmony case study is a Harvard Business School (HBR) case study written by Arthur I Segel, Mukti Khaire. The SOHO China: Design, Development, and Social Harmony (referred as “Soho Xin” 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 management, Organizational culture, Sales.

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 SOHO China: Design, Development, and Social Harmony Case Study

To maximize their effectiveness, color cases should be printed in color.Founded in 1995 by Zhang Xin and her husband Mr. Pan Shiyi, SOHO China has developed into a world-class real estate development firm that has consistently delivered high-quality projects known for their cutting-edge designs and investment potential. Despite the tremendous success of the firm, Zhang Xin still looks at the future with great uncertainty. Average residential pricing in China has dropped, as government continues to put downward pressure on residential housing prices through restrictions on the number of apartments a resident is allowed to purchase, and aggressive promotion of affordable housing on the low-end of the market. Zhang Xin wonders what opportunities and threats such market conditions present to SOHO. On the sales and marketing front, SOHO China has historically been geographically-focused only on high-end, design-driven projects in Shanghai and Beijing. As the market became more competitive, Zhang Xin wondered what key strategic decisions in regards to design, financing, and sales the company would need to make in order to maintain its competitive advantage in China.

Case Authors : Arthur I Segel, Mukti Khaire

Topic : Strategy & Execution

Related Areas : Financial management, Organizational culture, Sales

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Calculating Net Present Value (NPV) at 6% for SOHO China: Design, Development, and Social Harmony Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10019477)	-10019477	-	-
Year 1	3470130	-6549347	3470130	0.9434	3273708
Year 2	3978660	-2570687	7448790	0.89	3540993
Year 3	3960492	1389805	11409282	0.8396	3325305
Year 4	3233306	4623111	14642588	0.7921	2561081
TOTAL			14642588		12701087

The Net Present Value at 6% discount rate is 2681610

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 Soho Xin 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. Soho Xin 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 SOHO China: Design, Development, and Social Harmony

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 Soho Xin 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 Soho Xin 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	(10019477)	-10019477	-	-
Year 1	3470130	-6549347	3470130	0.8696	3017504
Year 2	3978660	-2570687	7448790	0.7561	3008439
Year 3	3960492	1389805	11409282	0.6575	2604088
Year 4	3233306	4623111	14642588	0.5718	1848653
TOTAL					10478684

The Net NPV after 4 years is 459207

(10478684 - 10019477 )

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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	(10019477)	-10019477	-	-
Year 1	3470130	-6549347	3470130	0.8333	2891775
Year 2	3978660	-2570687	7448790	0.6944	2762958
Year 3	3960492	1389805	11409282	0.5787	2291951
Year 4	3233306	4623111	14642588	0.4823	1559272
TOTAL					9505957

The Net NPV after 4 years is -513520

At 20% discount rate the NPV is negative (9505957 - 10019477 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Soho Xin 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 Soho Xin has a NPV value higher than Zero then finance managers at Soho Xin 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 Soho Xin, then the stock price of the Soho Xin 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 Soho Xin 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.

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.

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.

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 SOHO China: Design, Development, and Social Harmony

References & Further Readings

Arthur I Segel, Mukti Khaire (2018), "SOHO China: Design, Development, and Social Harmony Harvard Business Review Case Study. Published by HBR Publications.