×




GOME Home Appliance Co., Ltd. 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 GOME Home Appliance Co., Ltd. case study


At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. GOME Home Appliance Co., Ltd. case study is a Harvard Business School (HBR) case study written by Dongsheng Zhou, Kevin Lv. The GOME Home Appliance Co., Ltd. (referred as “Appliance Gome” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, Growth strategy, Reorganization.

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 GOME Home Appliance Co., Ltd. Case Study


Describes the evolution and growth of Gome Home Appliance and its recent restructuring in the context of the fierce competition in the home appliance retail industry. In just 15 years, Gome's founder Huang Guangyu, had led the company to grow to the largest home appliance retail chain in China in terms of sales. In spite of its impressive performance, however, the company felt pressure from internal management and external competition. To respond to these challenges and the changing environment of the industry, Gome started a major organizational restructuring in October 2002.


Case Authors : Dongsheng Zhou, Kevin Lv

Topic : Strategy & Execution

Related Areas : Growth strategy, Reorganization




Calculating Net Present Value (NPV) at 6% for GOME Home Appliance Co., Ltd. Case Study


Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Discounted
Cash Flows
Year 0 (10010931) -10010931 - -
Year 1 3469188 -6541743 3469188 0.9434 3272819
Year 2 3975100 -2566643 7444288 0.89 3537825
Year 3 3940149 1373506 11384437 0.8396 3308225
Year 4 3227688 4601194 14612125 0.7921 2556631
TOTAL 14612125 12675500




The Net Present Value at 6% discount rate is 2664569

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. Net Present Value
2. Profitability Index
3. Payback Period
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. Appliance Gome 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 Appliance Gome 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 GOME Home Appliance Co., Ltd.

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 Appliance Gome 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 Appliance Gome 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 (10010931) -10010931 - -
Year 1 3469188 -6541743 3469188 0.8696 3016685
Year 2 3975100 -2566643 7444288 0.7561 3005747
Year 3 3940149 1373506 11384437 0.6575 2590712
Year 4 3227688 4601194 14612125 0.5718 1845441
TOTAL 10458585


The Net NPV after 4 years is 447654

(10458585 - 10010931 )








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 (10010931) -10010931 - -
Year 1 3469188 -6541743 3469188 0.8333 2890990
Year 2 3975100 -2566643 7444288 0.6944 2760486
Year 3 3940149 1373506 11384437 0.5787 2280179
Year 4 3227688 4601194 14612125 0.4823 1556563
TOTAL 9488217


The Net NPV after 4 years is -522714

At 20% discount rate the NPV is negative (9488217 - 10010931 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Appliance Gome 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 Appliance Gome has a NPV value higher than Zero then finance managers at Appliance Gome 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 Appliance Gome, then the stock price of the Appliance Gome 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 Appliance Gome 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 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.

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.






Negotiation Strategy of GOME Home Appliance Co., Ltd.

References & Further Readings

Dongsheng Zhou, Kevin Lv (2018), "GOME Home Appliance Co., Ltd. Harvard Business Review Case Study. Published by HBR Publications.


Panama Petrochem Ltd SWOT Analysis / TOWS Matrix

Basic Materials , Chemical Manufacturing


Mondadori Editore SWOT Analysis / TOWS Matrix

Services , Printing & Publishing


Econach Holdings SWOT Analysis / TOWS Matrix

Consumer/Non-Cyclical , Personal & Household Prods.


Daishin Balance 2nd Special SWOT Analysis / TOWS Matrix

Technology , Electronic Instr. & Controls


China Touyun Tech SWOT Analysis / TOWS Matrix

Basic Materials , Containers & Packaging


Nextdecade SWOT Analysis / TOWS Matrix

Utilities , Natural Gas Utilities


Jpmorgan Gl SWOT Analysis / TOWS Matrix

Financial , Misc. Financial Services


Summit Ascent SWOT Analysis / TOWS Matrix

Capital Goods , Construction - Raw Materials


Sensorion SA SWOT Analysis / TOWS Matrix

Healthcare , Biotechnology & Drugs


SIT SWOT Analysis / TOWS Matrix

Technology , Electronic Instr. & Controls