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Building a More Intelligent Enterprise 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 Building a More Intelligent Enterprise case study


At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Building a More Intelligent Enterprise case study is a Harvard Business School (HBR) case study written by Paul J.H. Schoemaker, Philip E. Tetlock. The Building a More Intelligent Enterprise (referred as “Intelligent Intelligence” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, Strategy, Technology.

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 Building a More Intelligent Enterprise Case Study


This is an MIT Sloan Management Review article. To succeed in the long run, businesses need to create and leverage some kind of sustainable competitive edge. Although the authors say that advantages can still come from sources such as lower cost, intellectual property, motivated employees, and strategic leaders, they argue that in the knowledge economy, strategic advantages will increasingly depend on a capacity to make superior judgments and choices. Intelligent enterprises today are being shaped by two distinct forces. The first is the growing power of computers and big data, which provide the foundation for operations research, forecasting models, and artificial intelligence. The second is our growing understanding of human judgment, reasoning, and choice. Decades of research has yielded deep insights into what humans do well or poorly. In this article, the authors examine how managers can combine human intelligence with technology-enabled insights to make smarter choices in the face of uncertainty and complexity and thus gain a cumulative advantage in business. They note five strategic capabilities that intelligent enterprises can use to develop an advantage over competitors: 1. Find the strategic edge. In assessing past organizational forecasts, home in on areas where improving subjective predictions can really move the needle. 2. Run prediction tournaments. Discover the best forecasting methods by encouraging competition, experimentation, and innovation among teams. 3. Model the experts in your midst. Identify the people internally who have demonstrated superior insights into key business areas, and leverage their wisdom using simple linear models. 4. Experiment with artificial intelligence. Use deep neural nets in limited task domains to outperform human experts. 5. Change the way the organization operates. Promote an exploratory culture that continually looks for better ways to combine the capabilities of humans and machines.


Case Authors : Paul J.H. Schoemaker, Philip E. Tetlock

Topic : Strategy & Execution

Related Areas : Strategy, Technology




Calculating Net Present Value (NPV) at 6% for Building a More Intelligent Enterprise Case Study


Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Discounted
Cash Flows
Year 0 (10002767) -10002767 - -
Year 1 3466756 -6536011 3466756 0.9434 3270525
Year 2 3977822 -2558189 7444578 0.89 3540247
Year 3 3971115 1412926 11415693 0.8396 3334225
Year 4 3250893 4663819 14666586 0.7921 2575012
TOTAL 14666586 12720008


The Net Present Value at 6% discount rate is 2717241

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. 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 Intelligent Intelligence 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. Intelligent Intelligence 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 Building a More Intelligent Enterprise

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 Intelligent Intelligence 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 Intelligent Intelligence 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 (10002767) -10002767 - -
Year 1 3466756 -6536011 3466756 0.8696 3014570
Year 2 3977822 -2558189 7444578 0.7561 3007805
Year 3 3971115 1412926 11415693 0.6575 2611073
Year 4 3250893 4663819 14666586 0.5718 1858709
TOTAL 10492157


The Net NPV after 4 years is 489390

(10492157 - 10002767 )






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 (10002767) -10002767 - -
Year 1 3466756 -6536011 3466756 0.8333 2888963
Year 2 3977822 -2558189 7444578 0.6944 2762376
Year 3 3971115 1412926 11415693 0.5787 2298099
Year 4 3250893 4663819 14666586 0.4823 1567753
TOTAL 9517192


The Net NPV after 4 years is -485575

At 20% discount rate the NPV is negative (9517192 - 10002767 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Intelligent Intelligence 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 Intelligent Intelligence has a NPV value higher than Zero then finance managers at Intelligent Intelligence 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 Intelligent Intelligence, then the stock price of the Intelligent Intelligence 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 Intelligent Intelligence 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 –

Understanding of risks involved in 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 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.

What will be a multi year spillover effect of various taxation regulations.

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

Paul J.H. Schoemaker, Philip E. Tetlock (2018), "Building a More Intelligent Enterprise Harvard Business Review Case Study. Published by HBR Publications.