Introduction to Net Present Value (NPV) - What is Net Present Value (NPV) ? How it impacts financial decisions regarding project management?
At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. JCDecaux, 2016: Global Leader ... Again case study is a Harvard Business School (HBR) case study written by John R. Wells, Gabriel Ellsworth. The JCDecaux, 2016: Global Leader ... Again (referred as “Jcdecaux Jean” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, Business history, Business models, Competition, Customers, Design, Economy, Financial management, Globalization, Growth strategy, Human resource management, Joint ventures, Manufacturing, Mergers & acquisitions, Negotiations, Organizational structure, Performance measurement, Pricing, Product development, Public relations, Regulation, Technology, Work-life balance.
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.
In 2016, JCDecaux was number one in the world in outdoor advertising. This was a far cry from the situation in 2003; at that time, JCDecaux had been unseated by Clear Channel from the number-one spot that it had held for decades, and it was fighting for second place with OUTFRONT (then owned by Viacom). Over the 12 intervening years, JCDecaux had doubled in size, building leadership positions in China, Japan, Latin America, Africa, and Russia, and in 2010, it had passed Clear Channel to lead the industry once more. Now, co-CEOs Jean-FranA?ois Decaux and Jean-Charles Decaux were looking for new ways and new places to grow. After the company overtook Clear Channel in 2010, Jean-FranA?ois had indicated that he believed that another doubling in size was feasible, but it would probably take a major acquisition to do so. And JCDecaux faced more pressing short-term issues. The contract for London bus shelters that the company had won with much fanfare in August 2015 was behind schedule. To make matters worse, the United Kingdom's June 2016 "Brexit" vote to leave the European Union cast a shadow over the project, and the markets reacted negatively. By the start of November, JCDecaux's share price had fallen 21% since the beginning of the year. Just what the economic uncertainty of Brexit would mean for global outdoor advertising in general, and U.K. outdoor advertising in particular, was not clear. Doubling in size in such an environment appeared a daunting task.
| Years | Cash Flow | Net Cash Flow | Cumulative Cash Flow |
Discount Rate @ 6 % |
Discounted Cash Flows |
|---|---|---|---|---|---|
| Year 0 | (10026674) | -10026674 | - | - | |
| Year 1 | 3458133 | -6568541 | 3458133 | 0.9434 | 3262390 |
| Year 2 | 3982244 | -2586297 | 7440377 | 0.89 | 3544183 |
| Year 3 | 3945929 | 1359632 | 11386306 | 0.8396 | 3313078 |
| Year 4 | 3230200 | 4589832 | 14616506 | 0.7921 | 2558621 |
| TOTAL | 14616506 | 12678272 |
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 -
Capital Budgeting Approaches
There are four types of capital budgeting techniques that are widely used in the corporate world –
1. Profitability Index
2. Payback Period
3. Internal Rate of Return
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. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Jcdecaux Jean 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 Jcdecaux Jean have higher preference for cash returns over 4-5 years rather than 10-15 years given the nature of the volatility in the 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
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 Jcdecaux Jean 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 Jcdecaux Jean 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.
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 | (10026674) | -10026674 | - | - | |
| Year 1 | 3458133 | -6568541 | 3458133 | 0.8696 | 3007072 |
| Year 2 | 3982244 | -2586297 | 7440377 | 0.7561 | 3011149 |
| Year 3 | 3945929 | 1359632 | 11386306 | 0.6575 | 2594512 |
| Year 4 | 3230200 | 4589832 | 14616506 | 0.5718 | 1846877 |
| TOTAL | 10459610 |
(10459610 - 10026674 )
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 | (10026674) | -10026674 | - | - | |
| Year 1 | 3458133 | -6568541 | 3458133 | 0.8333 | 2881778 |
| Year 2 | 3982244 | -2586297 | 7440377 | 0.6944 | 2765447 |
| Year 3 | 3945929 | 1359632 | 11386306 | 0.5787 | 2283524 |
| Year 4 | 3230200 | 4589832 | 14616506 | 0.4823 | 1557774 |
| TOTAL | 9488522 |
At 20% discount rate the NPV is negative (9488522 - 10026674 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Jcdecaux Jean to discount cash flow at lower discount rates such as 15%.
Simplest Approach – If the investment project of Jcdecaux Jean has a NPV value higher than Zero then finance managers at Jcdecaux Jean 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 Jcdecaux Jean, then the stock price of the Jcdecaux Jean 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.
Project selection is often a far more complex decision than just choosing it based on the NPV number. Finance managers at Jcdecaux Jean 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 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.
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.
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.
John R. Wells, Gabriel Ellsworth (2018), "JCDecaux, 2016: Global Leader ... Again Harvard Business Review Case Study. Published by HBR Publications.
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