Options for growth: The case of Haier (B) 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 Options for growth: The case of Haier (B) case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Options for growth: The case of Haier (B) case study is a Harvard Business School (HBR) case study written by Franziska Frank. The Options for growth: The case of Haier (B) (referred as “Ruimin Refrigerators” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, Innovation, Leadership, Mergers & acquisitions.

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 Options for growth: The case of Haier (B) Case Study

The cases focus on how Zhang Ruimin, CEO of the Qingdao refrigerator factory, managed to turn around a nearly bankrupt factory which produced bad quality refrigerators into one of the world's largest white goods producers. With a series of rigorous steps, Ruimin succeeded in improving the quality of the refrigerators by putting the right incentives and processes into place. In addition, he expanded the product range into other areas of the white goods sector, and last but not least, moved aggressively into foreign markets with inroads into the largest and most competitive markets of America and Europe.

Case Authors : Franziska Frank

Topic : Strategy & Execution

Related Areas : Innovation, Leadership, Mergers & acquisitions

---

Calculating Net Present Value (NPV) at 6% for Options for growth: The case of Haier (B) Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10015430)	-10015430	-	-
Year 1	3473052	-6542378	3473052	0.9434	3276464
Year 2	3960659	-2581719	7433711	0.89	3524972
Year 3	3960388	1378669	11394099	0.8396	3325218
Year 4	3224657	4603326	14618756	0.7921	2554230
TOTAL			14618756		12680885

The Net Present Value at 6% discount rate is 2665455

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. Payback Period
2. Net Present Value
3. Internal Rate of Return
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. Ruimin Refrigerators 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 Ruimin Refrigerators have higher preference for cash returns over 4-5 years rather than 10-15 years given the nature of the volatility in the industry.

---

Formula and Steps to Calculate Net Present Value (NPV) of Options for growth: The case of Haier (B)

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 Ruimin Refrigerators 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 Ruimin Refrigerators 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	(10015430)	-10015430	-	-
Year 1	3473052	-6542378	3473052	0.8696	3020045
Year 2	3960659	-2581719	7433711	0.7561	2994827
Year 3	3960388	1378669	11394099	0.6575	2604019
Year 4	3224657	4603326	14618756	0.5718	1843708
TOTAL					10462600

The Net NPV after 4 years is 447170

(10462600 - 10015430 )

---

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	(10015430)	-10015430	-	-
Year 1	3473052	-6542378	3473052	0.8333	2894210
Year 2	3960659	-2581719	7433711	0.6944	2750458
Year 3	3960388	1378669	11394099	0.5787	2291891
Year 4	3224657	4603326	14618756	0.4823	1555101
TOTAL					9491660

The Net NPV after 4 years is -523770

At 20% discount rate the NPV is negative (9491660 - 10015430 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Ruimin Refrigerators 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 Ruimin Refrigerators has a NPV value higher than Zero then finance managers at Ruimin Refrigerators 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 Ruimin Refrigerators, then the stock price of the Ruimin Refrigerators 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 Ruimin Refrigerators 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 can impact the cash flow of 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 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.

---

Negotiation Strategy of Options for growth: The case of Haier (B)

References & Further Readings

Franziska Frank (2018), "Options for growth: The case of Haier (B) Harvard Business Review Case Study. Published by HBR Publications.