Majestica Hotel in Shanghai? 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 Majestica Hotel in Shanghai? case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Majestica Hotel in Shanghai? case study is a Harvard Business School (HBR) case study written by Paul W. Beamish, Jane Lu. The Majestica Hotel in Shanghai? (referred as “Majestica Shanghai” 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 culture.

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 Majestica Hotel in Shanghai? Case Study

Majestica Hotels Inc., a leading European operator of luxury hotels, was trying to reach an agreement with Commercial Properties of Shanghai regarding the management contract for a new hotel in Shanghai. A series of issues require resolution for the deal to proceed, including length of contract term, name, and staffing. Majestica was reluctant to make further concessions for fear that doing so might jeopardize its service culture, arguably the key success factor in this industry. At issue was whether Majestica should adopt a contingency approach and relax its operating philosophy or stick to its principles, even if it meant not entering a lucrative market.

Case Authors : Paul W. Beamish, Jane Lu

Topic : Technology & Operations

Related Areas : Organizational culture

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Calculating Net Present Value (NPV) at 6% for Majestica Hotel in Shanghai? Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10023940)	-10023940	-	-
Year 1	3456081	-6567859	3456081	0.9434	3260454
Year 2	3957235	-2610624	7413316	0.89	3521925
Year 3	3953458	1342834	11366774	0.8396	3319400
Year 4	3238424	4581258	14605198	0.7921	2565135
TOTAL			14605198		12666914

The Net Present Value at 6% discount rate is 2642974

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. Internal Rate of Return
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 Majestica Shanghai 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. Majestica Shanghai 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 Majestica Hotel in Shanghai?

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 Majestica Shanghai 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 Majestica Shanghai 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	(10023940)	-10023940	-	-
Year 1	3456081	-6567859	3456081	0.8696	3005288
Year 2	3957235	-2610624	7413316	0.7561	2992238
Year 3	3953458	1342834	11366774	0.6575	2599463
Year 4	3238424	4581258	14605198	0.5718	1851579
TOTAL					10448568

The Net NPV after 4 years is 424628

(10448568 - 10023940 )

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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	(10023940)	-10023940	-	-
Year 1	3456081	-6567859	3456081	0.8333	2880068
Year 2	3957235	-2610624	7413316	0.6944	2748080
Year 3	3953458	1342834	11366774	0.5787	2287881
Year 4	3238424	4581258	14605198	0.4823	1561740
TOTAL					9477768

The Net NPV after 4 years is -546172

At 20% discount rate the NPV is negative (9477768 - 10023940 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Majestica Shanghai 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 Majestica Shanghai has a NPV value higher than Zero then finance managers at Majestica Shanghai 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 Majestica Shanghai, then the stock price of the Majestica Shanghai 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 Majestica Shanghai 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 can impact the cash flow of the project.

Understanding of risks involved in the project.

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.

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 Majestica Hotel in Shanghai?

References & Further Readings

Paul W. Beamish, Jane Lu (2018), "Majestica Hotel in Shanghai? Harvard Business Review Case Study. Published by HBR Publications.