AFP Provida, Spanish Version 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 AFP Provida, Spanish Version case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. AFP Provida, Spanish Version case study is a Harvard Business School (HBR) case study written by Michael E. Porter, Andrea Prado, Arturo Condo. The AFP Provida, Spanish Version (referred as “Provida Afp” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, Economic development, Emerging markets, Globalization, Growth strategy, Joint ventures, 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 AFP Provida, Spanish Version Case Study

Describes the evolution of AFP Provida, one of the early entrants into the Chilean pension fund system established in 1981. By 1999, AFP Provida was not only the largest pension fund administrator in Chile, but also the largest in Latin America in terms of number of affiliates and the second largest in terms of assets under management, after the Brazilian company Previ. Provida was also the most international firm in the industry. At the turn of the 20th century, Provida's senior management was considering how to extend the company's position in a rapidly expanding international marketplace. Describes the firm's internationalization process in terms of timing, geographic choices, and modes of entry. Also discusses Chilean special conditions for the pension fund industry, including local factors, context for strategy and rivalry, demand conditions, and related and supporting industries. Allows for the discussion of the origins of clusters in developing economies as well as the sources of international competitive advantage. Also provides an interesting evaluation of Provida's strategic choices and the sustainability of its international leadership.

Case Authors : Michael E. Porter, Andrea Prado, Arturo Condo

Topic : Strategy & Execution

Related Areas : Economic development, Emerging markets, Globalization, Growth strategy, Joint ventures, Sales

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Calculating Net Present Value (NPV) at 6% for AFP Provida, Spanish Version Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10024549)	-10024549	-	-
Year 1	3458436	-6566113	3458436	0.9434	3262675
Year 2	3957672	-2608441	7416108	0.89	3522314
Year 3	3967316	1358875	11383424	0.8396	3331035
Year 4	3236788	4595663	14620212	0.7921	2563839
TOTAL			14620212		12679864

The Net Present Value at 6% discount rate is 2655315

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

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 Provida Afp 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. Provida Afp 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 AFP Provida, Spanish Version

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 Provida Afp 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 Provida Afp 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	(10024549)	-10024549	-	-
Year 1	3458436	-6566113	3458436	0.8696	3007336
Year 2	3957672	-2608441	7416108	0.7561	2992569
Year 3	3967316	1358875	11383424	0.6575	2608575
Year 4	3236788	4595663	14620212	0.5718	1850644
TOTAL					10459123

The Net NPV after 4 years is 434574

(10459123 - 10024549 )

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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	(10024549)	-10024549	-	-
Year 1	3458436	-6566113	3458436	0.8333	2882030
Year 2	3957672	-2608441	7416108	0.6944	2748383
Year 3	3967316	1358875	11383424	0.5787	2295900
Year 4	3236788	4595663	14620212	0.4823	1560951
TOTAL					9487265

The Net NPV after 4 years is -537284

At 20% discount rate the NPV is negative (9487265 - 10024549 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Provida Afp 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 Provida Afp has a NPV value higher than Zero then finance managers at Provida Afp 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 Provida Afp, then the stock price of the Provida Afp 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 Provida Afp 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 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 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 can impact the cash flow of the project.

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 AFP Provida, Spanish Version

References & Further Readings

Michael E. Porter, Andrea Prado, Arturo Condo (2018), "AFP Provida, Spanish Version Harvard Business Review Case Study. Published by HBR Publications.