Electronic Cigarettes in the EU: The Political Economy of Product Regulation 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 Electronic Cigarettes in the EU: The Political Economy of Product Regulation case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Electronic Cigarettes in the EU: The Political Economy of Product Regulation case study is a Harvard Business School (HBR) case study written by Nicola Persico, Chen Cheng, Nicola Scocchi. The Electronic Cigarettes in the EU: The Political Economy of Product Regulation (referred as “Cigarette Eu” 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

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Case Description of Electronic Cigarettes in the EU: The Political Economy of Product Regulation Case Study

You are the CEO of an e-cigarette company that has just been acquired by a major tobacco company. Your company operates in the European market. The July 2013 draft of the EU Tobacco Products Directive (TPD) recently has been crafted by the European Commission, but it has not yet been examined by the EU Parliament and its Council. The draft proposes that all e-cigarette products be classified as medical devices, regardless of nicotine content. This is the strictest available mode of regulation. If the directive goes into effect as written, e-cigarettes would have to undergo costly and lengthy clinical trials to receive approval and face much stricter marketability restrictions. The case details the state of the e-cigarette industry in 2013, including consumer data, distribution, competition from similar products, and public health concerns. Students will analyze the current regulatory environment, determine what outcome would be most favorable to the e-cigarette industry, and identify the ways to achieve that goal.

Case Authors : Nicola Persico, Chen Cheng, Nicola Scocchi

Topic : Strategy & Execution

Related Areas :

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Calculating Net Present Value (NPV) at 6% for Electronic Cigarettes in the EU: The Political Economy of Product Regulation Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10003959)	-10003959	-	-
Year 1	3444108	-6559851	3444108	0.9434	3249158
Year 2	3958370	-2601481	7402478	0.89	3522935
Year 3	3949727	1348246	11352205	0.8396	3316267
Year 4	3238469	4586715	14590674	0.7921	2565171
TOTAL			14590674		12653531

The Net Present Value at 6% discount rate is 2649572

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. Profitability Index
2. Internal Rate of Return
3. Net Present Value
4. Payback Period

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 Cigarette Eu 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. Cigarette Eu 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 Electronic Cigarettes in the EU: The Political Economy of Product Regulation

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 Cigarette Eu 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 Cigarette Eu 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	(10003959)	-10003959	-	-
Year 1	3444108	-6559851	3444108	0.8696	2994877
Year 2	3958370	-2601481	7402478	0.7561	2993096
Year 3	3949727	1348246	11352205	0.6575	2597010
Year 4	3238469	4586715	14590674	0.5718	1851605
TOTAL					10436588

The Net NPV after 4 years is 432629

(10436588 - 10003959 )

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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	(10003959)	-10003959	-	-
Year 1	3444108	-6559851	3444108	0.8333	2870090
Year 2	3958370	-2601481	7402478	0.6944	2748868
Year 3	3949727	1348246	11352205	0.5787	2285722
Year 4	3238469	4586715	14590674	0.4823	1561762
TOTAL					9466441

The Net NPV after 4 years is -537518

At 20% discount rate the NPV is negative (9466441 - 10003959 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Cigarette Eu 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 Cigarette Eu has a NPV value higher than Zero then finance managers at Cigarette Eu 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 Cigarette Eu, then the stock price of the Cigarette Eu 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 Cigarette Eu 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 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.

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.

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 Electronic Cigarettes in the EU: The Political Economy of Product Regulation

References & Further Readings

Nicola Persico, Chen Cheng, Nicola Scocchi (2018), "Electronic Cigarettes in the EU: The Political Economy of Product Regulation Harvard Business Review Case Study. Published by HBR Publications.