Target Systems: Challenges and Opportunities in the Electronic Health Information System Arena 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 Target Systems: Challenges and Opportunities in the Electronic Health Information System Arena case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Target Systems: Challenges and Opportunities in the Electronic Health Information System Arena case study is a Harvard Business School (HBR) case study written by Michael J. Fratantuono, David M Sarcone. The Target Systems: Challenges and Opportunities in the Electronic Health Information System Arena (referred as “Arena Ehi” 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 Target Systems: Challenges and Opportunities in the Electronic Health Information System Arena Case Study

In the summer of 2010, the members of the business development team of Target Systems were carefully considering the possibility of entering the Electronic Health Information (EHI) systems arena. The company had both breadth and depth of experience in providing logistics, project management and information technology (IT) services to clients in the public and private sector. Although the employees of Target Systems were experts in a full range of IT services, no one in the company had deep expertise about the way IT applications were being used to manage patient care or administer health care organizations. The lack of expertise implied that a movement by Target Systems into the EHI systems arena would call for the company to simultaneously develop new products and services for a new set of clients -- to engage in growth by related diversification. That strategy would stand in contrast to the growth by concentration strategy the team had employed throughout company history. To pursue a diversification strategy the team would have to decide if it should provide services to regional health information organizations, hospitals or individual physicians' practices. It would also have to decide whether it would cultivate new capabilities by investing in internal development or by seeking a strategic partner that was already operating in the arena. Ultimately, the way the business development team weighed the opportunities versus the challenges of adopting a new growth strategy in the context of a still uncertain external environment would strongly influence its decision as to whether or not the company should enter this new arena.

Case Authors : Michael J. Fratantuono, David M Sarcone

Topic : Strategy & Execution

Related Areas :

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Calculating Net Present Value (NPV) at 6% for Target Systems: Challenges and Opportunities in the Electronic Health Information System Arena Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10004267)	-10004267	-	-
Year 1	3472338	-6531929	3472338	0.9434	3275791
Year 2	3960542	-2571387	7432880	0.89	3524868
Year 3	3944688	1373301	11377568	0.8396	3312036
Year 4	3230497	4603798	14608065	0.7921	2558856
TOTAL			14608065		12671551

The Net Present Value at 6% discount rate is 2667284

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. Internal Rate of Return
2. Net Present Value
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. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Arena Ehi 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 Arena Ehi have higher preference for cash returns over 4-5 years rather than 10-15 years given the nature of the volatility in the industry.

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Formula and Steps to Calculate Net Present Value (NPV) of Target Systems: Challenges and Opportunities in the Electronic Health Information System Arena

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 Arena Ehi 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 Arena Ehi 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	(10004267)	-10004267	-	-
Year 1	3472338	-6531929	3472338	0.8696	3019424
Year 2	3960542	-2571387	7432880	0.7561	2994739
Year 3	3944688	1373301	11377568	0.6575	2593696
Year 4	3230497	4603798	14608065	0.5718	1847047
TOTAL					10454907

The Net NPV after 4 years is 450640

(10454907 - 10004267 )

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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	(10004267)	-10004267	-	-
Year 1	3472338	-6531929	3472338	0.8333	2893615
Year 2	3960542	-2571387	7432880	0.6944	2750376
Year 3	3944688	1373301	11377568	0.5787	2282806
Year 4	3230497	4603798	14608065	0.4823	1557917
TOTAL					9484714

The Net NPV after 4 years is -519553

At 20% discount rate the NPV is negative (9484714 - 10004267 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Arena Ehi 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 Arena Ehi has a NPV value higher than Zero then finance managers at Arena Ehi 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 Arena Ehi, then the stock price of the Arena Ehi 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 Arena Ehi 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.

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.

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 Target Systems: Challenges and Opportunities in the Electronic Health Information System Arena

References & Further Readings

Michael J. Fratantuono, David M Sarcone (2018), "Target Systems: Challenges and Opportunities in the Electronic Health Information System Arena Harvard Business Review Case Study. Published by HBR Publications.