End of Corporate Computing 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 End of Corporate Computing case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. End of Corporate Computing case study is a Harvard Business School (HBR) case study written by Nicholas G. Carr. The End of Corporate Computing (referred as “Computing Virtualization” from here on) case study provides evaluation & decision scenario in field of Technology & Operations. It also touches upon business topics such as - Value proposition, Organizational structure.

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 End of Corporate Computing Case Study

This is an MIT Sloan Management Review article. Information technology is undergoing an inexorable shift from being an asset that companies own to being a service that they purchase from utility providers. Three technological advances are enabling this change: virtualization, grid computing, and Web services. Virtualization erases the differences between proprietary computing platforms, enabling applications designed to run on one operating system to be deployed elsewhere. Grid computing allows large numbers of hardware components, such as servers or disk drives, to effectively act as a single device, pooling their capacity and allocating it automatically to different jobs. Web services standardize the interfaces between applications, turning them into modules that can be assembled and disassembled easily. The resulting industry will likely have three major components. At the center will be the IT utilities themselves--big companies that will maintain core computing resources in central plants and distribute them to end users. Serving the utilities will be a diverse array of component suppliers--the makers of computers, storage units, networking gear, operating and utility software, and applications. And finally, large network operators will maintain the ultra-high-capacity data communication lines needed for the system to work. IT's shift from an in-house capital asset to a centralized utility service will overturn strategic and operating assumptions, alter industrial economics, upset markets, and pose daunting challenges to every user and vendor.

Case Authors : Nicholas G. Carr

Topic : Technology & Operations

Related Areas : Organizational structure

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Calculating Net Present Value (NPV) at 6% for End of Corporate Computing Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10005896)	-10005896	-	-
Year 1	3446091	-6559805	3446091	0.9434	3251029
Year 2	3980486	-2579319	7426577	0.89	3542618
Year 3	3967321	1388002	11393898	0.8396	3331039
Year 4	3224360	4612362	14618258	0.7921	2553995
TOTAL			14618258		12678682

The Net Present Value at 6% discount rate is 2672786

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. Net Present Value
2. Payback Period
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 Computing Virtualization 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. Computing Virtualization 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 End of Corporate Computing

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 Technology & Operations 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 Computing Virtualization 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 Computing Virtualization 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	(10005896)	-10005896	-	-
Year 1	3446091	-6559805	3446091	0.8696	2996601
Year 2	3980486	-2579319	7426577	0.7561	3009819
Year 3	3967321	1388002	11393898	0.6575	2608578
Year 4	3224360	4612362	14618258	0.5718	1843538
TOTAL					10458536

The Net NPV after 4 years is 452640

(10458536 - 10005896 )

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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	(10005896)	-10005896	-	-
Year 1	3446091	-6559805	3446091	0.8333	2871743
Year 2	3980486	-2579319	7426577	0.6944	2764226
Year 3	3967321	1388002	11393898	0.5787	2295903
Year 4	3224360	4612362	14618258	0.4823	1554958
TOTAL					9486830

The Net NPV after 4 years is -519066

At 20% discount rate the NPV is negative (9486830 - 10005896 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Computing Virtualization 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 Computing Virtualization has a NPV value higher than Zero then finance managers at Computing Virtualization 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 Computing Virtualization, then the stock price of the Computing Virtualization 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 Computing Virtualization 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.

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.

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.

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 End of Corporate Computing

References & Further Readings

Nicholas G. Carr (2018), "End of Corporate Computing Harvard Business Review Case Study. Published by HBR Publications.