Closing the Gap Between Strategy and Execution 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 Closing the Gap Between Strategy and Execution case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Closing the Gap Between Strategy and Execution case study is a Harvard Business School (HBR) case study written by Donald N. Sull. The Closing the Gap Between Strategy and Execution (referred as “Loop Interactions” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, Leadership.

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 Closing the Gap Between Strategy and Execution Case Study

This is an MIT Sloan Management Review article. Many markets are affected by the complex interactions of multiple variables: geopolitics, technical innovation, capital market swings, competitive dynamics, shifting consumer preferences, and so on. These volatile markets throw out a steady stream of opportunities and threats, and managers can neither predict nor control the form, magnitude, or timing of future events with accuracy. In such environments, the traditional linear view of strategy--plan then execute--is woefully inadequate because it hinders people from incorporating new information into action. But instead of thinking of strategy as a linear process, why not consider it as inherently iterative--a loop instead of a line? According to this view, every strategy is a work in progress that is subject to revision in light of ongoing interactions between the organization and its shifting environment. To accommodate those interactions, the strategy loop consists of four major steps: making sense of a situation, making choices on what to do (and what not to do), making those things happen, and making revisions based on new information. Reconceptualizing strategy as an iterative loop is simple enough, but putting that new mindset into practice is not. Here, the crucial thing to remember is that discussions--formal and informal, short and long, one-on-one and in groups--are the key mechanism for coordinating activity inside a company. Thus, to put the strategy loop into practice, managers at every level in the organization must be proficient at leading discussions that reflect the four major steps (making sense, making choices, making things happen, and making revisions). Companies such as Diageo Ireland, All America Latina Logistica, and Onset Venture Services demonstrate that each of the four types of discussions has a different objective that requires a specific tone, supporting information, leadership traits, and accompanying tactics.

Case Authors : Donald N. Sull

Topic : Strategy & Execution

Related Areas : Leadership

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Calculating Net Present Value (NPV) at 6% for Closing the Gap Between Strategy and Execution Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10007461)	-10007461	-	-
Year 1	3453997	-6553464	3453997	0.9434	3258488
Year 2	3955187	-2598277	7409184	0.89	3520102
Year 3	3956065	1357788	11365249	0.8396	3321588
Year 4	3235599	4593387	14600848	0.7921	2562897
TOTAL			14600848		12663076

The Net Present Value at 6% discount rate is 2655615

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. Payback Period
2. Internal Rate of Return
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 Loop Interactions 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. Loop Interactions 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 Closing the Gap Between Strategy and Execution

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 Loop Interactions 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 Loop Interactions 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	(10007461)	-10007461	-	-
Year 1	3453997	-6553464	3453997	0.8696	3003476
Year 2	3955187	-2598277	7409184	0.7561	2990690
Year 3	3956065	1357788	11365249	0.6575	2601177
Year 4	3235599	4593387	14600848	0.5718	1849964
TOTAL					10445306

The Net NPV after 4 years is 437845

(10445306 - 10007461 )

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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	(10007461)	-10007461	-	-
Year 1	3453997	-6553464	3453997	0.8333	2878331
Year 2	3955187	-2598277	7409184	0.6944	2746658
Year 3	3956065	1357788	11365249	0.5787	2289389
Year 4	3235599	4593387	14600848	0.4823	1560378
TOTAL					9474756

The Net NPV after 4 years is -532705

At 20% discount rate the NPV is negative (9474756 - 10007461 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Loop Interactions 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 Loop Interactions has a NPV value higher than Zero then finance managers at Loop Interactions 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 Loop Interactions, then the stock price of the Loop Interactions 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 Loop Interactions 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.

Understanding of risks involved in the project.

What will be a multi year spillover effect of various taxation regulations.

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 Closing the Gap Between Strategy and Execution

References & Further Readings

Donald N. Sull (2018), "Closing the Gap Between Strategy and Execution Harvard Business Review Case Study. Published by HBR Publications.