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General Electric vs. Westinghouse in Large Turbine Generators (A) 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 General Electric vs. Westinghouse in Large Turbine Generators (A) case study


At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. General Electric vs. Westinghouse in Large Turbine Generators (A) case study is a Harvard Business School (HBR) case study written by Michael E. Porter. The General Electric vs. Westinghouse in Large Turbine Generators (A) (referred as “Warfare Turbine” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, Change management, Competition, Customers, Financial markets, Pricing, Regulation, 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




Case Description of General Electric vs. Westinghouse in Large Turbine Generators (A) Case Study


Describes the U.S. large turbine generator industry in early 1963, a period of severe price cutting and depressed industry conditions. Presents data to allow a structural analysis of the industry and an analysis of the strategies of the major players since 1946. The major teaching issue is the process of competitive rivalry in an oligopoly market, particularly the problems of deescalating in a situation of market warfare. This industry is one where the conditions for avoiding warfare are difficult. Subsidiary teaching issues include the structural analysis of capital goods markets and strategy for the market leader in areas like pricing, rate of technological change, and customer focus. After understanding the industry structure, the discussion should turn to what GE can do to extricate itself from the disastrous price cutting afflicting the industry.


Case Authors : Michael E. Porter

Topic : Strategy & Execution

Related Areas : Change management, Competition, Customers, Financial markets, Pricing, Regulation, Technology




Calculating Net Present Value (NPV) at 6% for General Electric vs. Westinghouse in Large Turbine Generators (A) Case Study


Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Discounted
Cash Flows
Year 0 (10015040) -10015040 - -
Year 1 3446348 -6568692 3446348 0.9434 3251272
Year 2 3975028 -2593664 7421376 0.89 3537761
Year 3 3943521 1349857 11364897 0.8396 3311056
Year 4 3245086 4594943 14609983 0.7921 2570412
TOTAL 14609983 12670501


The Net Present Value at 6% discount rate is 2655461

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. 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 Warfare Turbine 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. Warfare Turbine 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 General Electric vs. Westinghouse in Large Turbine Generators (A)

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 Warfare Turbine 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 Warfare Turbine 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 (10015040) -10015040 - -
Year 1 3446348 -6568692 3446348 0.8696 2996824
Year 2 3975028 -2593664 7421376 0.7561 3005692
Year 3 3943521 1349857 11364897 0.6575 2592929
Year 4 3245086 4594943 14609983 0.5718 1855388
TOTAL 10450834


The Net NPV after 4 years is 435794

(10450834 - 10015040 )






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 (10015040) -10015040 - -
Year 1 3446348 -6568692 3446348 0.8333 2871957
Year 2 3975028 -2593664 7421376 0.6944 2760436
Year 3 3943521 1349857 11364897 0.5787 2282130
Year 4 3245086 4594943 14609983 0.4823 1564953
TOTAL 9479476


The Net NPV after 4 years is -535564

At 20% discount rate the NPV is negative (9479476 - 10015040 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Warfare Turbine 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 Warfare Turbine has a NPV value higher than Zero then finance managers at Warfare Turbine 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 Warfare Turbine, then the stock price of the Warfare Turbine 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 Warfare Turbine 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 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.

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

Understanding of risks involved in 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.




References & Further Readings

Michael E. Porter (2018), "General Electric vs. Westinghouse in Large Turbine Generators (A) Harvard Business Review Case Study. Published by HBR Publications.