I-Star: Expanding in North America 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 I-Star: Expanding in North America case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. I-Star: Expanding in North America case study is a Harvard Business School (HBR) case study written by William Wei, Yang Xiaohua, Roger Chen, Kimberley Howard. The I-Star: Expanding in North America (referred as “Star America” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, Marketing, Strategy.

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 I-Star: Expanding in North America Case Study

The president of I-Star America, Inc. and vice-president of I-Star Corporation reflected on the success of I-Star in the Chinese and Japanese IT markets and the challenges of increasing market share in North America, one of the largest markets in the world. I-Star was expected to grow about 30 per cent in the next few years, and the president considered whether the strategy used in Japan could be applied to North America. Many Chinese firms that experienced success in China were less successful in international (western) markets for a host of reasons, including failure to adapt business processes and products to the new market and the perception that Chinese goods and services might be of lower quality. The president believed that I-Star's past and future success relied on the company's ability to innovate in creating value for its customers. He believed that with the right strategy I-Star could generate revenues of US$50-100 million and build up a cadre of more than 200 employees in the software and services division in North America. How could I-Star increase its brand awareness and presence in North America to best achieve these goals?

Case Authors : William Wei, Yang Xiaohua, Roger Chen, Kimberley Howard

Topic : Strategy & Execution

Related Areas : Marketing, Strategy

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Calculating Net Present Value (NPV) at 6% for I-Star: Expanding in North America Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10005344)	-10005344	-	-
Year 1	3459064	-6546280	3459064	0.9434	3263268
Year 2	3972628	-2573652	7431692	0.89	3535625
Year 3	3974991	1401339	11406683	0.8396	3337479
Year 4	3249631	4650970	14656314	0.7921	2574012
TOTAL			14656314		12710384

The Net Present Value at 6% discount rate is 2705040

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

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. Star America 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 Star America 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 I-Star: Expanding in North America

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 Star America 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 Star America 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	(10005344)	-10005344	-	-
Year 1	3459064	-6546280	3459064	0.8696	3007882
Year 2	3972628	-2573652	7431692	0.7561	3003878
Year 3	3974991	1401339	11406683	0.6575	2613621
Year 4	3249631	4650970	14656314	0.5718	1857987
TOTAL					10483367

The Net NPV after 4 years is 478023

(10483367 - 10005344 )

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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	(10005344)	-10005344	-	-
Year 1	3459064	-6546280	3459064	0.8333	2882553
Year 2	3972628	-2573652	7431692	0.6944	2758769
Year 3	3974991	1401339	11406683	0.5787	2300342
Year 4	3249631	4650970	14656314	0.4823	1567145
TOTAL					9508809

The Net NPV after 4 years is -496535

At 20% discount rate the NPV is negative (9508809 - 10005344 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Star America 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 Star America has a NPV value higher than Zero then finance managers at Star America 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 Star America, then the stock price of the Star America 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 Star America 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 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 will be a multi year spillover effect of various taxation regulations.

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.

What can impact the cash flow of 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 I-Star: Expanding in North America

References & Further Readings

William Wei, Yang Xiaohua, Roger Chen, Kimberley Howard (2018), "I-Star: Expanding in North America Harvard Business Review Case Study. Published by HBR Publications.