Red Hat Global Support Services: The Move to Relationship-based Customer Servicing and Knowledge-centered Support 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 Red Hat Global Support Services: The Move to Relationship-based Customer Servicing and Knowledge-centered Support case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Red Hat Global Support Services: The Move to Relationship-based Customer Servicing and Knowledge-centered Support case study is a Harvard Business School (HBR) case study written by Richard M. Kesner. The Red Hat Global Support Services: The Move to Relationship-based Customer Servicing and Knowledge-centered Support (referred as “Hat Red” from here on) case study provides evaluation & decision scenario in field of Technology & Operations. It also touches upon business topics such as - Value proposition, IT, Supply chain.

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 Red Hat Global Support Services: The Move to Relationship-based Customer Servicing and Knowledge-centered Support Case Study

In the 1990's, Red Hat established itself as a leading proponent of the open source software movement and sought to carve out for itself a significant role in the open source marketplace. As of 2011, the company reported $177 million in Non-GAAP operating income in FY2010, based on revenues of $748 million. Red Hat's market capitalization was set at $8 billion as of January 25, 2011. It operated 65 offices worldwide, including 12 Global Support Service Centers, and employed 3,580 people. The Red Hat brand is most closely associated with Linux even though their stable of product offerings grew to include a number of other noteworthy system software and middleware products, such as JBoss and Red Hat Enterprise Virtualization. As Red Hat's Linux product line came to be widely accepted as a enterprise software platform, the company transformed its thinking about and delivery of customer support. This case study explores the innovative ways that Red Hat went about this transformartion process.

Case Authors : Richard M. Kesner

Topic : Technology & Operations

Related Areas : IT, Supply chain

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Calculating Net Present Value (NPV) at 6% for Red Hat Global Support Services: The Move to Relationship-based Customer Servicing and Knowledge-centered Support Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10022717)	-10022717	-	-
Year 1	3457216	-6565501	3457216	0.9434	3261525
Year 2	3970234	-2595267	7427450	0.89	3533494
Year 3	3958356	1363089	11385806	0.8396	3323512
Year 4	3223702	4586791	14609508	0.7921	2553474
TOTAL			14609508		12672005

The Net Present Value at 6% discount rate is 2649288

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. Profitability Index
3. Internal Rate of Return
4. Payback Period

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 Hat Red 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. Hat Red 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 Red Hat Global Support Services: The Move to Relationship-based Customer Servicing and Knowledge-centered Support

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 Hat Red 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 Hat Red 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	(10022717)	-10022717	-	-
Year 1	3457216	-6565501	3457216	0.8696	3006275
Year 2	3970234	-2595267	7427450	0.7561	3002067
Year 3	3958356	1363089	11385806	0.6575	2602683
Year 4	3223702	4586791	14609508	0.5718	1843162
TOTAL					10454187

The Net NPV after 4 years is 431470

(10454187 - 10022717 )

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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	(10022717)	-10022717	-	-
Year 1	3457216	-6565501	3457216	0.8333	2881013
Year 2	3970234	-2595267	7427450	0.6944	2757107
Year 3	3958356	1363089	11385806	0.5787	2290715
Year 4	3223702	4586791	14609508	0.4823	1554640
TOTAL					9483476

The Net NPV after 4 years is -539241

At 20% discount rate the NPV is negative (9483476 - 10022717 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Hat Red 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 Hat Red has a NPV value higher than Zero then finance managers at Hat Red 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 Hat Red, then the stock price of the Hat Red 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 Hat Red 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.

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Negotiation Strategy of Red Hat Global Support Services: The Move to Relationship-based Customer Servicing and Knowledge-centered Support

References & Further Readings

Richard M. Kesner (2018), "Red Hat Global Support Services: The Move to Relationship-based Customer Servicing and Knowledge-centered Support Harvard Business Review Case Study. Published by HBR Publications.