L'Atelier Art Lounge: Times of Uncertainty 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 L'Atelier Art Lounge: Times of Uncertainty case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. L'Atelier Art Lounge: Times of Uncertainty case study is a Harvard Business School (HBR) case study written by Randa Salamoun, Bettina Bastian. The L'Atelier Art Lounge: Times of Uncertainty (referred as “Beirut L'atelier” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, Gender.

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 L'Atelier Art Lounge: Times of Uncertainty Case Study

On January 31, 2014, the founder and chief executive officer of L'Atelier Art Lounge, an art workshop with branches in Bahrain and Lebanon, faces numerous challenges: not only whether to grow the business but how to achieve a reasonable work-life balance. Political instability associated with the Arab Spring led her to close one of her shops in Bahrain, but she went ahead with opening a second in Beirut where there are few leisure activities available for children; her offering of educational entertainment has been welcomed by parents, schools and adults looking to revive a hobby or improve their skills. However, as a result of violence spilling over from Syria, many tourists are avoiding Lebanon and her store locations have experienced a dramatic decrease in customers. Now she has one day to decide whether to renew the lease of one of her outlets. This deadline represents an opportunity to consider her options for the future: should she focus on marketing her concept to increase the number of customers and consequently her bottom line, thus improving her cash flow; look for potential investors or apply for a bank loan; or close her least profitable location? Randa Salamoun is affiliated with American University of Beirut. Bettina Bastian is affiliated with American University of Beirut.

Case Authors : Randa Salamoun, Bettina Bastian

Topic : Strategy & Execution

Related Areas : Gender

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Calculating Net Present Value (NPV) at 6% for L'Atelier Art Lounge: Times of Uncertainty Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10011591)	-10011591	-	-
Year 1	3472678	-6538913	3472678	0.9434	3276111
Year 2	3973847	-2565066	7446525	0.89	3536710
Year 3	3958924	1393858	11405449	0.8396	3323989
Year 4	3247128	4640986	14652577	0.7921	2572030
TOTAL			14652577		12708839

The Net Present Value at 6% discount rate is 2697248

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. Payback Period
3. Net Present Value
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 Beirut L'atelier 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. Beirut L'atelier 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 L'Atelier Art Lounge: Times of Uncertainty

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 Beirut L'atelier 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 Beirut L'atelier 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	(10011591)	-10011591	-	-
Year 1	3472678	-6538913	3472678	0.8696	3019720
Year 2	3973847	-2565066	7446525	0.7561	3004799
Year 3	3958924	1393858	11405449	0.6575	2603057
Year 4	3247128	4640986	14652577	0.5718	1856556
TOTAL					10484132

The Net NPV after 4 years is 472541

(10484132 - 10011591 )

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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	(10011591)	-10011591	-	-
Year 1	3472678	-6538913	3472678	0.8333	2893898
Year 2	3973847	-2565066	7446525	0.6944	2759616
Year 3	3958924	1393858	11405449	0.5787	2291044
Year 4	3247128	4640986	14652577	0.4823	1565938
TOTAL					9510496

The Net NPV after 4 years is -501095

At 20% discount rate the NPV is negative (9510496 - 10011591 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Beirut L'atelier 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 Beirut L'atelier has a NPV value higher than Zero then finance managers at Beirut L'atelier 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 Beirut L'atelier, then the stock price of the Beirut L'atelier 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 Beirut L'atelier 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 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 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 L'Atelier Art Lounge: Times of Uncertainty

References & Further Readings

Randa Salamoun, Bettina Bastian (2018), "L'Atelier Art Lounge: Times of Uncertainty Harvard Business Review Case Study. Published by HBR Publications.