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SAS Real Estate: To Fire or Not to Fire? 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 SAS Real Estate: To Fire or Not to Fire? case study


At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. SAS Real Estate: To Fire or Not to Fire? case study is a Harvard Business School (HBR) case study written by Zunaira Saqib, Sara Mashhadi, Khan Rafia Danish, Memoona Khalid. The SAS Real Estate: To Fire or Not to Fire? (referred as “Fire Employee” 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 SAS Real Estate: To Fire or Not to Fire? Case Study


A real estate company in a highly competitive market in Pakistan was the recent victim of employee theft. A fraudulent bank transaction had occurred, which risked the firm's smooth functioning and future operations, as well as customer confidence. The company had suspicions about an employee who might have been involved in the theft, but the CEO was facing the dilemma of whether to fire him or not. The employee was the only one who could operate the company's complex financial software. If the CEO decided to replace the employee based on his suspicion, he would be facing major replacement and training costs, and also causing a delay in the company's upcoming mega project. However, if he did not fire him, it would mean that the company was tolerant of such acts, which could lead to future corruption. Zunaira Saqib is affiliated with National University of Sciences and Technology,Islamabad.


Case Authors : Zunaira Saqib, Sara Mashhadi, Khan Rafia Danish, Memoona Khalid

Topic : Strategy & Execution

Related Areas :




Calculating Net Present Value (NPV) at 6% for SAS Real Estate: To Fire or Not to Fire? Case Study


Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Discounted
Cash Flows
Year 0 (10021188) -10021188 - -
Year 1 3463708 -6557480 3463708 0.9434 3267649
Year 2 3957781 -2599699 7421489 0.89 3522411
Year 3 3951811 1352112 11373300 0.8396 3318017
Year 4 3246982 4599094 14620282 0.7921 2571914
TOTAL 14620282 12679991


The Net Present Value at 6% discount rate is 2658803

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. Profitability Index
2. Net Present Value
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. Timing of the expected cash flows – stockholders of Fire Employee 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. Fire Employee shareholders have preference for diversified projects investment rather than prospective high income from a single capital intensive project.




Formula and Steps to Calculate Net Present Value (NPV) of SAS Real Estate: To Fire or Not to Fire?

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 Fire Employee 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 Fire Employee 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 (10021188) -10021188 - -
Year 1 3463708 -6557480 3463708 0.8696 3011920
Year 2 3957781 -2599699 7421489 0.7561 2992651
Year 3 3951811 1352112 11373300 0.6575 2598380
Year 4 3246982 4599094 14620282 0.5718 1856472
TOTAL 10459423


The Net NPV after 4 years is 438235

(10459423 - 10021188 )






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 (10021188) -10021188 - -
Year 1 3463708 -6557480 3463708 0.8333 2886423
Year 2 3957781 -2599699 7421489 0.6944 2748459
Year 3 3951811 1352112 11373300 0.5787 2286928
Year 4 3246982 4599094 14620282 0.4823 1565867
TOTAL 9487677


The Net NPV after 4 years is -533511

At 20% discount rate the NPV is negative (9487677 - 10021188 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Fire Employee 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 Fire Employee has a NPV value higher than Zero then finance managers at Fire Employee 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 Fire Employee, then the stock price of the Fire Employee 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 Fire Employee 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 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.

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.

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.




References & Further Readings

Zunaira Saqib, Sara Mashhadi, Khan Rafia Danish, Memoona Khalid (2018), "SAS Real Estate: To Fire or Not to Fire? Harvard Business Review Case Study. Published by HBR Publications.