REfficient: Preparing for Growth 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 REfficient: Preparing for Growth case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. REfficient: Preparing for Growth case study is a Harvard Business School (HBR) case study written by David Sparling, Ken Mark. The REfficient: Preparing for Growth (referred as “Refficient Ontario” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, Project management.

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 REfficient: Preparing for Growth Case Study

In early 2011, the founder of REfficient, an asset recovery service based in Hamilton, Ontario, was thinking about how she should manage the rapid growth that seemed just around the corner. Founded in 2010 to help cable firms generate value from their stock of surplus equipment, REfficient, with no direct competitors in the Ontario market, had grown rapidly and had a list of corporate customers, two warehouses and five employees. The company was positioned as the efficient way for customers to recover value from their surplus assets; it would collect and inventory them, provide an online list and track the environmental impact of selling or discarding them. The company was now looking to secure a pilot project with the Ontario provincial government. Innovative in the "green" sense because of its innovative reuse, recycle or resell model, as well as its integrated carbon footprint estimator, REfficient was a good match for the program. But how would it deal with an increasingly large variety of items, given its limited resources and space?

Case Authors : David Sparling, Ken Mark

Topic : Strategy & Execution

Related Areas : Project management

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Calculating Net Present Value (NPV) at 6% for REfficient: Preparing for Growth Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10005232)	-10005232	-	-
Year 1	3471333	-6533899	3471333	0.9434	3274842
Year 2	3966994	-2566905	7438327	0.89	3530611
Year 3	3942004	1375099	11380331	0.8396	3309783
Year 4	3246077	4621176	14626408	0.7921	2571197
TOTAL			14626408		12686433

The Net Present Value at 6% discount rate is 2681201

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. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Refficient Ontario 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 Refficient Ontario 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 REfficient: Preparing for Growth

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 Refficient Ontario 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 Refficient Ontario 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	(10005232)	-10005232	-	-
Year 1	3471333	-6533899	3471333	0.8696	3018550
Year 2	3966994	-2566905	7438327	0.7561	2999617
Year 3	3942004	1375099	11380331	0.6575	2591932
Year 4	3246077	4621176	14626408	0.5718	1855955
TOTAL					10466055

The Net NPV after 4 years is 460823

(10466055 - 10005232 )

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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	(10005232)	-10005232	-	-
Year 1	3471333	-6533899	3471333	0.8333	2892778
Year 2	3966994	-2566905	7438327	0.6944	2754857
Year 3	3942004	1375099	11380331	0.5787	2281252
Year 4	3246077	4621176	14626408	0.4823	1565431
TOTAL					9494317

The Net NPV after 4 years is -510915

At 20% discount rate the NPV is negative (9494317 - 10005232 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Refficient Ontario 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 Refficient Ontario has a NPV value higher than Zero then finance managers at Refficient Ontario 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 Refficient Ontario, then the stock price of the Refficient Ontario 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 Refficient Ontario 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.

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

What can impact the cash flow of the project.

Understanding of risks involved in 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 REfficient: Preparing for Growth

References & Further Readings

David Sparling, Ken Mark (2018), "REfficient: Preparing for Growth Harvard Business Review Case Study. Published by HBR Publications.