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Chain Saw Industry in 1978 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 Chain Saw Industry in 1978 case study


At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Chain Saw Industry in 1978 case study is a Harvard Business School (HBR) case study written by Michael E. Porter, David J. Collis, James Debelina, Jon Elsasser. The Chain Saw Industry in 1978 (referred as “Evolution 1974” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, Competition, Competitive strategy, Economy, Forecasting, Operations management.

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 Chain Saw Industry in 1978 Case Study


For use on the second day of a two-day sequence on the U.S. chain saw industry. Describes the evolution of the industry since 1974. Illustrates issues in industry evolution, the forces causing evolution, and the strategic issues raised by evolution. The discussion can center around understanding the 1974-78 time period, and then on an analysis of the future. The class can be asked to take the perspective of different major competitors.


Case Authors : Michael E. Porter, David J. Collis, James Debelina, Jon Elsasser

Topic : Strategy & Execution

Related Areas : Competition, Competitive strategy, Economy, Forecasting, Operations management




Calculating Net Present Value (NPV) at 6% for Chain Saw Industry in 1978 Case Study


Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Discounted
Cash Flows
Year 0 (10018477) -10018477 - -
Year 1 3468068 -6550409 3468068 0.9434 3271762
Year 2 3966739 -2583670 7434807 0.89 3530384
Year 3 3952281 1368611 11387088 0.8396 3318411
Year 4 3234579 4603190 14621667 0.7921 2562090
TOTAL 14621667 12682647


The Net Present Value at 6% discount rate is 2664170

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. Internal Rate of Return
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 Evolution 1974 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. Evolution 1974 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 Chain Saw Industry in 1978

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 Evolution 1974 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 Evolution 1974 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 (10018477) -10018477 - -
Year 1 3468068 -6550409 3468068 0.8696 3015711
Year 2 3966739 -2583670 7434807 0.7561 2999425
Year 3 3952281 1368611 11387088 0.6575 2598689
Year 4 3234579 4603190 14621667 0.5718 1849381
TOTAL 10463206


The Net NPV after 4 years is 444729

(10463206 - 10018477 )






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 (10018477) -10018477 - -
Year 1 3468068 -6550409 3468068 0.8333 2890057
Year 2 3966739 -2583670 7434807 0.6944 2754680
Year 3 3952281 1368611 11387088 0.5787 2287200
Year 4 3234579 4603190 14621667 0.4823 1559886
TOTAL 9491822


The Net NPV after 4 years is -526655

At 20% discount rate the NPV is negative (9491822 - 10018477 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Evolution 1974 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 Evolution 1974 has a NPV value higher than Zero then finance managers at Evolution 1974 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 Evolution 1974, then the stock price of the Evolution 1974 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 Evolution 1974 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 can impact the cash flow of the project.

Understanding of risks involved in the project.

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.

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

Michael E. Porter, David J. Collis, James Debelina, Jon Elsasser (2018), "Chain Saw Industry in 1978 Harvard Business Review Case Study. Published by HBR Publications.