The New Value Imperative for Privately held companies: The Why, What, and How of value Management Strategy 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 The New Value Imperative for Privately held companies: The Why, What, and How of value Management Strategy case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. The New Value Imperative for Privately held companies: The Why, What, and How of value Management Strategy case study is a Harvard Business School (HBR) case study written by John W. Hill, Thomas L. Zeller. The The New Value Imperative for Privately held companies: The Why, What, and How of value Management Strategy (referred as “A Privately” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, Costs, Growth 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 The New Value Imperative for Privately held companies: The Why, What, and How of value Management Strategy Case Study

This discussion describes the why, what, and how of managing for value in privately held companies. Public companies continue to manage for value, a trend that is now pushing its way inexorably into privately held companies. First, we discuss the dynamics that are creating a value-management imperative for these companies. Second, we provide a signaling model to assist management of privately held companies in deciding whether to emphasize (a) revenue growth, (b) the spread between return on invested capital and the weighted average cost of capital, (c) reduction in the cost of capital, or (d) some combination of these three. The key-value-driver model provides guidance in addressing questions such as: Do we have the right to grow? Should we improve profit performance before we grow? What is our performance in relation to our cost of capital? We also describe how to acquire the data necessary to use the model. Third, we present some important but under-utilized tools based upon transactions cost and strategic cost management theories to assist executives in managing for value and discuss when to apply these tools within a strategic context. a??a??a??a??a??

Case Authors : John W. Hill, Thomas L. Zeller

Topic : Strategy & Execution

Related Areas : Costs, Growth strategy

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Calculating Net Present Value (NPV) at 6% for The New Value Imperative for Privately held companies: The Why, What, and How of value Management Strategy Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10027493)	-10027493	-	-
Year 1	3462395	-6565098	3462395	0.9434	3266410
Year 2	3982817	-2582281	7445212	0.89	3544693
Year 3	3965756	1383475	11410968	0.8396	3329725
Year 4	3248703	4632178	14659671	0.7921	2573277
TOTAL			14659671		12714106

The Net Present Value at 6% discount rate is 2686613

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. Internal Rate of Return
4. Net Present Value

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 A Privately 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. A Privately 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 The New Value Imperative for Privately held companies: The Why, What, and How of value Management Strategy

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 A Privately 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 A Privately 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	(10027493)	-10027493	-	-
Year 1	3462395	-6565098	3462395	0.8696	3010778
Year 2	3982817	-2582281	7445212	0.7561	3011582
Year 3	3965756	1383475	11410968	0.6575	2607549
Year 4	3248703	4632178	14659671	0.5718	1857456
TOTAL					10487366

The Net NPV after 4 years is 459873

(10487366 - 10027493 )

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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	(10027493)	-10027493	-	-
Year 1	3462395	-6565098	3462395	0.8333	2885329
Year 2	3982817	-2582281	7445212	0.6944	2765845
Year 3	3965756	1383475	11410968	0.5787	2294998
Year 4	3248703	4632178	14659671	0.4823	1566697
TOTAL					9512869

The Net NPV after 4 years is -514624

At 20% discount rate the NPV is negative (9512869 - 10027493 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of A Privately 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 A Privately has a NPV value higher than Zero then finance managers at A Privately 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 A Privately, then the stock price of the A Privately 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 A Privately 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.

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.

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 The New Value Imperative for Privately held companies: The Why, What, and How of value Management Strategy

References & Further Readings

John W. Hill, Thomas L. Zeller (2018), "The New Value Imperative for Privately held companies: The Why, What, and How of value Management Strategy Harvard Business Review Case Study. Published by HBR Publications.