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Opening the Valve: From Software to Hardware (B) 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 Opening the Valve: From Software to Hardware (B) case study


At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Opening the Valve: From Software to Hardware (B) case study is a Harvard Business School (HBR) case study written by Ethan S. Bernstein, Francesca Gino, Bradley R. Staats. The Opening the Valve: From Software to Hardware (B) (referred as “Valve's Valve” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, Design, Human resource management, Leading teams, Managing yourself, Organizational culture, Organizational structure, Strategy.

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 Opening the Valve: From Software to Hardware (B) Case Study


Valve, one of the world's top video game software companies, has also become an iconic example of an organization with virtually no hierarchy. A 400-person organization, Valve's unique organizational form (described in detail in the case and accompanying employee handbook) includes 100% self-allocated time, no managers (and therefore no managerial oversight), a structure so fluid that all desks have wheels to allow free movement between ""cabals"" (teams) on a regular basis (which happens frequently enough that Valve created a homegrown tracking app to allow peers to find each other), a unique hiring apparatus that supports recruitment of T-shaped individuals, and a purely peer-based performance review and stack ranking. As customer demand and market forces draw Valve into hardware in 2013, Valve questions whether their organizational model will need to change as it expands from software into hardware-and, if so, whether they should prioritize strategy over structure or structure over strategy. The case therefore presents students with a strategic and organizational challenge which tests students' understanding, and Valve's resolve, with regard to the congruence between their organizational model and strategic direction. Students should have read and discussed the (A) case, and Valve's options for entering hardware, prior to the (B) case being distributed. The (B) case provides significant detail on Valve's initial decisions but keeps the final outcome as a work-in-process. Students should have read and discussed the (A) case, and Valve's options for entering hardware, prior to the (B) case being distributed. The (B) case provides significant detail on Valve's initial decisions but keeps the final outcome as a work-in-process.


Case Authors : Ethan S. Bernstein, Francesca Gino, Bradley R. Staats

Topic : Strategy & Execution

Related Areas : Design, Human resource management, Leading teams, Managing yourself, Organizational culture, Organizational structure, Strategy




Calculating Net Present Value (NPV) at 6% for Opening the Valve: From Software to Hardware (B) Case Study


Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Discounted
Cash Flows
Year 0 (10006226) -10006226 - -
Year 1 3457292 -6548934 3457292 0.9434 3261596
Year 2 3980643 -2568291 7437935 0.89 3542758
Year 3 3942735 1374444 11380670 0.8396 3310396
Year 4 3246529 4620973 14627199 0.7921 2571555
TOTAL 14627199 12686306




The Net Present Value at 6% discount rate is 2680080

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. 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. Valve's Valve 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 Valve's Valve have higher preference for cash returns over 4-5 years rather than 10-15 years given the nature of the volatility in the industry.






Formula and Steps to Calculate Net Present Value (NPV) of Opening the Valve: From Software to Hardware (B)

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 Valve's Valve 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 Valve's Valve 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 (10006226) -10006226 - -
Year 1 3457292 -6548934 3457292 0.8696 3006341
Year 2 3980643 -2568291 7437935 0.7561 3009938
Year 3 3942735 1374444 11380670 0.6575 2592412
Year 4 3246529 4620973 14627199 0.5718 1856213
TOTAL 10464905


The Net NPV after 4 years is 458679

(10464905 - 10006226 )








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 (10006226) -10006226 - -
Year 1 3457292 -6548934 3457292 0.8333 2881077
Year 2 3980643 -2568291 7437935 0.6944 2764335
Year 3 3942735 1374444 11380670 0.5787 2281675
Year 4 3246529 4620973 14627199 0.4823 1565649
TOTAL 9492736


The Net NPV after 4 years is -513490

At 20% discount rate the NPV is negative (9492736 - 10006226 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Valve's Valve 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 Valve's Valve has a NPV value higher than Zero then finance managers at Valve's Valve 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 Valve's Valve, then the stock price of the Valve's Valve 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 Valve's Valve 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 will be a multi year spillover effect of various taxation regulations.

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.

Understanding of risks involved in 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.






Negotiation Strategy of Opening the Valve: From Software to Hardware (B)

References & Further Readings

Ethan S. Bernstein, Francesca Gino, Bradley R. Staats (2018), "Opening the Valve: From Software to Hardware (B) Harvard Business Review Case Study. Published by HBR Publications.


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