Strategy Made Simple: Thinking in Threes 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 Strategy Made Simple: Thinking in Threes case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Strategy Made Simple: Thinking in Threes case study is a Harvard Business School (HBR) case study written by Robert W. Keidel. The Strategy Made Simple: Thinking in Threes (referred as “Disjunction Containment” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, 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 Strategy Made Simple: Thinking in Threes Case Study

In this increasingly complex world, managers understandably seek experts' advice to chart a path forward. Yet they encounter a jumble of metaphors, methods, and models; too often, old wine in new bottles. This article helps managers cut through the clutter. It presents a triangular framework which integrates concepts that, despite contrasting language, are more similar than different. The schema is based on the three kinds of Venn diagram: disjunction, containment, and intersection. Disjunction implies autonomy; containment, control; and intersection, cooperation. Every organizational strategy is a balance of these three variables. Once the triadic pattern has been grasped, managers can 'speed-read' the literatures on strategy, technology/organization, mergers and acquisitions, and cognition-as well as see parallels across these writings. They also become better able to address strategic issues systemically and efficiently, and to communicate to a wide organizational audience.

Case Authors : Robert W. Keidel

Topic : Strategy & Execution

Related Areas : Mergers & acquisitions

Calculating Net Present Value (NPV) at 6% for Strategy Made Simple: Thinking in Threes Case Study

Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Cash Flows
Year 0 (10027130) -10027130 - -
Year 1 3451503 -6575627 3451503 0.9434 3256135
Year 2 3958240 -2617387 7409743 0.89 3522820
Year 3 3967348 1349961 11377091 0.8396 3331062
Year 4 3249397 4599358 14626488 0.7921 2573827
TOTAL 14626488 12683843

The Net Present Value at 6% discount rate is 2656713

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. Profitability Index
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. Timing of the expected cash flows – stockholders of Disjunction Containment 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. Disjunction Containment shareholders have preference for diversified projects investment rather than prospective high income from a single capital intensive project.

Formula and Steps to Calculate Net Present Value (NPV) of Strategy Made Simple: Thinking in Threes

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 Disjunction Containment 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 Disjunction Containment 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 %
Cash Flows
Year 0 (10027130) -10027130 - -
Year 1 3451503 -6575627 3451503 0.8696 3001307
Year 2 3958240 -2617387 7409743 0.7561 2992998
Year 3 3967348 1349961 11377091 0.6575 2608596
Year 4 3249397 4599358 14626488 0.5718 1857853
TOTAL 10460754

The Net NPV after 4 years is 433624

(10460754 - 10027130 )

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 %
Cash Flows
Year 0 (10027130) -10027130 - -
Year 1 3451503 -6575627 3451503 0.8333 2876253
Year 2 3958240 -2617387 7409743 0.6944 2748778
Year 3 3967348 1349961 11377091 0.5787 2295919
Year 4 3249397 4599358 14626488 0.4823 1567032
TOTAL 9487981

The Net NPV after 4 years is -539149

At 20% discount rate the NPV is negative (9487981 - 10027130 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Disjunction Containment 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 Disjunction Containment has a NPV value higher than Zero then finance managers at Disjunction Containment 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 Disjunction Containment, then the stock price of the Disjunction Containment 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 Disjunction Containment 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 can impact the cash flow of the project.

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 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.

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.

References & Further Readings

Robert W. Keidel (2018), "Strategy Made Simple: Thinking in Threes Harvard Business Review Case Study. Published by HBR Publications.