The Opportunity Paradox 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 Opportunity Paradox case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. The Opportunity Paradox case study is a Harvard Business School (HBR) case study written by Christopher B. Bingham, Nathan R. Furr, Kathleen M. Eisenhardt. The The Opportunity Paradox (referred as “Opportunity Selection” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, .

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 Opportunity Paradox Case Study

This is an MIT Sloan Management Review article. Capturing new growth opportunities is fundamental to strategy, innovation and entrepreneurship. These days, experimentation and improvisational change are in. But how should managers address the challenge? The answer, the authors argue, can be more complex and more crucial to a company's success than previously thought. Their research on mature corporations, growing businesses and new ventures suggests a paradoxical tension between focus and flexibility that can define or break a business. Based on more than 150 interviews with managers at 30 companies in North America, Europe and Asia, the authors conclude that focus is still critical and may be just as important as flexibility. What's more, they conclude that a company's focus may influence its flexibility and vice versa. There are two components to capturing a new business opportunity: opportunity selection and opportunity execution. Opportunity selection involves determining which customer problem to solve, whereas opportunity execution deals with solving the problem. The authors point out that most books, articles and thought leaders focus on opportunity execution -how to create value by developing solutions. But research suggests that innovation initiatives often move so quickly to identify a solution that the innovators have to cycle back to figure out which problem they are actually solving. The authors found that opportunity selection appears to matter as much as opportunity execution. More importantly, how managers approach opportunity selection (whether with flexibility or with focus) has a critical impact on how successful they are at opportunity execution. The authors observed that managers and entrepreneurs tend to fall into two groups: opportunists and strategists. Opportunists rely on a less scripted and more flexible approach to opportunity selection, letting emergent customer inquiries shape opportunity selection. Strategists follow a different pattern. They constrain the selection of opportunities so that they pursue opportunities that are more likely to result in success, and they try to capture several opportunities in a row versus one in isolation. The authors found that companies that were more focused in opportunity selection were often more flexible in opportunity execution.

Case Authors : Christopher B. Bingham, Nathan R. Furr, Kathleen M. Eisenhardt

Topic : Strategy & Execution

Related Areas :

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Calculating Net Present Value (NPV) at 6% for The Opportunity Paradox Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10016239)	-10016239	-	-
Year 1	3444474	-6571765	3444474	0.9434	3249504
Year 2	3954666	-2617099	7399140	0.89	3519639
Year 3	3972586	1355487	11371726	0.8396	3335460
Year 4	3245294	4600781	14617020	0.7921	2570577
TOTAL			14617020		12675179

The Net Present Value at 6% discount rate is 2658940

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. 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. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Opportunity Selection 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 Opportunity Selection have higher preference for cash returns over 4-5 years rather than 10-15 years given the nature of the volatility in the industry.

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Formula and Steps to Calculate Net Present Value (NPV) of The Opportunity Paradox

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 Opportunity Selection 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 Opportunity Selection 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	(10016239)	-10016239	-	-
Year 1	3444474	-6571765	3444474	0.8696	2995195
Year 2	3954666	-2617099	7399140	0.7561	2990296
Year 3	3972586	1355487	11371726	0.6575	2612040
Year 4	3245294	4600781	14617020	0.5718	1855507
TOTAL					10453038

The Net NPV after 4 years is 436799

(10453038 - 10016239 )

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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	(10016239)	-10016239	-	-
Year 1	3444474	-6571765	3444474	0.8333	2870395
Year 2	3954666	-2617099	7399140	0.6944	2746296
Year 3	3972586	1355487	11371726	0.5787	2298950
Year 4	3245294	4600781	14617020	0.4823	1565053
TOTAL					9480694

The Net NPV after 4 years is -535545

At 20% discount rate the NPV is negative (9480694 - 10016239 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Opportunity Selection 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 Opportunity Selection has a NPV value higher than Zero then finance managers at Opportunity Selection 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 Opportunity Selection, then the stock price of the Opportunity Selection 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 Opportunity Selection 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 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.

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 Opportunity Paradox

References & Further Readings

Christopher B. Bingham, Nathan R. Furr, Kathleen M. Eisenhardt (2018), "The Opportunity Paradox Harvard Business Review Case Study. Published by HBR Publications.