Integrating Innovation Style and Knowledge Into 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 Integrating Innovation Style and Knowledge Into Strategy case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Integrating Innovation Style and Knowledge Into Strategy case study is a Harvard Business School (HBR) case study written by Edward F. McDonough, Michael Zack, Hsing-Er Lin, Iris Berdrow. The Integrating Innovation Style and Knowledge Into Strategy (referred as “Positions Knowledge” 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, Technology.

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 Integrating Innovation Style and Knowledge Into Strategy Case Study

This is an MIT Sloan Management Review article. The way we think about strategy is woefully incomplete, the authors contend. The traditional idea of focusing on the positioning of products (or services) underplays much of what most would agree makes a company truly competitive. Not only does it give short shrift to what a company knows, it ignores completely the fact that in today's dynamic economy, organizations have to continually reinvent who they are and what they do in large and small ways. And one important means of doing so is through innovation. An effective strategy, then, is comprised of three key components: product/market, knowledge and innovation positions. But even if a company masters the three strategic positions of product/market, knowledge and innovation independently, it is still at risk. Only when all three positions are aligned and mutually reinforcing can a strategy succeed. In adopting the notion of alignment, organizations need to view each position -- product/market, knowledge and innovation -- as aspects of an organization's overall strategy. Creating an integrated strategy thus requires focusing not on each position separately, but rather on all three positions simultaneously. The authors introduce the notion of competing based not only on what an organization makes or the service it provides, but on what it knows and how it innovates. Each aspect represents a competitive position that must be evaluated relative to the capabilities of the organization and to others in the marketplace battling for the same space. And each component must not only be aligned with the other two, but it needs to be adjusted as circumstances warrant. When done correctly, organizations -- such as Buckman Laboratories, which is profiled here -- thrive. When done badly, the company can suffer, and perhaps fatally so, as the history of Polaroid points out.

Case Authors : Edward F. McDonough, Michael Zack, Hsing-Er Lin, Iris Berdrow

Topic : Strategy & Execution

Related Areas : Innovation, Technology

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Calculating Net Present Value (NPV) at 6% for Integrating Innovation Style and Knowledge Into Strategy Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10002628)	-10002628	-	-
Year 1	3460771	-6541857	3460771	0.9434	3264878
Year 2	3979869	-2561988	7440640	0.89	3542069
Year 3	3970525	1408537	11411165	0.8396	3333729
Year 4	3240840	4649377	14652005	0.7921	2567049
TOTAL			14652005		12707726

The Net Present Value at 6% discount rate is 2705098

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. Net Present Value
3. Profitability Index
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 Positions Knowledge 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. Positions Knowledge 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 Integrating Innovation Style and Knowledge Into 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 Positions Knowledge 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 Positions Knowledge 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	(10002628)	-10002628	-	-
Year 1	3460771	-6541857	3460771	0.8696	3009366
Year 2	3979869	-2561988	7440640	0.7561	3009353
Year 3	3970525	1408537	11411165	0.6575	2610685
Year 4	3240840	4649377	14652005	0.5718	1852961
TOTAL					10482364

The Net NPV after 4 years is 479736

(10482364 - 10002628 )

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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	(10002628)	-10002628	-	-
Year 1	3460771	-6541857	3460771	0.8333	2883976
Year 2	3979869	-2561988	7440640	0.6944	2763798
Year 3	3970525	1408537	11411165	0.5787	2297758
Year 4	3240840	4649377	14652005	0.4823	1562905
TOTAL					9508436

The Net NPV after 4 years is -494192

At 20% discount rate the NPV is negative (9508436 - 10002628 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Positions Knowledge 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 Positions Knowledge has a NPV value higher than Zero then finance managers at Positions Knowledge 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 Positions Knowledge, then the stock price of the Positions Knowledge 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 Positions Knowledge 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 will be a multi year spillover effect of various taxation regulations.

Understanding of risks involved in the project.

What can impact the cash flow of 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.

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Negotiation Strategy of Integrating Innovation Style and Knowledge Into Strategy

References & Further Readings

Edward F. McDonough, Michael Zack, Hsing-Er Lin, Iris Berdrow (2018), "Integrating Innovation Style and Knowledge Into Strategy Harvard Business Review Case Study. Published by HBR Publications.